{"id":1234,"date":"2012-07-22T11:36:20","date_gmt":"2012-07-22T11:36:20","guid":{"rendered":"http:\/\/www.knowfinance.com\/?p=1234"},"modified":"2012-07-22T11:36:20","modified_gmt":"2012-07-22T11:36:20","slug":"put-option","status":"publish","type":"post","link":"https:\/\/www2.stockmarketwatch.com\/learn\/put-option\/","title":{"rendered":"Put Option"},"content":{"rendered":"

A\u00a0put\u00a0or\u00a0put option\u00a0is a deal between two parties to exchange an underlying instrument, at a predetermined price (the\u00a0strike), by a specified date (also referred to as a maturity date).<\/p>\n

While one party, the buyer of the put, has the right, but no obligation, to sell the underlying instrument at the strike price by the future date,\u00a0 the other party, the seller of the put, has the obligation to purchase the asset at the strike price should the buyer exercises the option.<\/p>\n

If the strike is denoted by\u00a0K\u00a0and T stands for the maturity time, now, the buyer exercises the put at a time\u00a0t, the buyer can anticipate to receive a payout of\u00a0K-S (t), if the price of the underlying\u00a0S(t)\u00a0at that time is lower than\u00a0K.<\/p>\n

The option deal must occur by time\u00a0T; as the time of the execution is clearly specified by the type of put option. In the United States, an option\u00a0can be exercised at any time before or equal to\u00a0T; while in\u00a0European option it can be exercised only at time\u00a0T.<\/p>\n

A\u00a0Bermudan option\u00a0can be exercised only on those dates which are listed in the terms of the contract. Should the option is not exercised by maturity, it expires valueless. (Remember that the buyer will not exercise the option on specified date if the price of the underlying is greater than\u00a0K.)<\/p>\n

The most obvious use of a put is as a type of insurance. In the\u00a0protective put\u00a0strategy, the investor buys enough puts to protect their holdings of the underlying asset so that if a significant downward movement of the underlying instrument\u2019s price happens, they have the option to sell the holdings at the strike price. Put option\u2019s another use is for speculation: an investor can take a short position in the underlying instrument without getting directly involved trading.<\/p>\n

Puts may also be combined with some other derivatives as part of more intricate investment strategies (also referred to as financial engineering) , and in particular, may be useful for\u00a0hedging.<\/p>\n

With the help of put-call parity, a European put can be changed by buying the appropriate\u00a0call option\u00a0and selling an appropriate\u00a0forward contract.<\/p>\n

Instrument Models<\/p>\n

The terms for exercising the option’s right to sell – varies, depending upon the\u00a0option style. A\u00a0European put option\u00a0lets the holder to exercise the put option for a short period of time right before the date of maturity, while an\u00a0American put option\u00a0gives right to exercise at any time before expiration.<\/p>\n

The most extensively-traded put options are on\u00a0equities; however they are traded on many other instruments such as\u00a0interest rates or\u00a0commodities.<\/p>\n

The put\u00a0buyer\u00a0either hopes that the underlying instrument\u2019s price will drop by the exercise date or anticipates protecting a long position in it. The benefit of buying a put over\u00a0short selling the asset is that the option owner’s risk of loss is restricted to the premium paid for it, whereas the asset short seller’s risk of loss can stretch to any extent (its price can increase greatly, in fact, in theory it can rise substantially, and such a rise is the short seller’s loss). The put buyer’s hope (risk) of gain is limited to the option’s strike price minus the underlying instrument\u2019s spot price and the premium\/fee paid for it.<\/p>\n

The put\u00a0writer\u00a0expects that the underlying security’s price will increase, not lessen. The writer sells the put to obtain the premium. The put writer’s entire potential loss is restricted to the put’s strike price minus the spot and premium previously received. Puts can be also exercised to minimize the writer’s portfolio risk and may be part of an\u00a0option spread.<\/p>\n

The put buyer is short on the underlying asset of the put, but at the same time long on the put option itself. To be exact, the buyer hopes the value of the put option to rise by a fall in the price of the underlying asset below the strike price. The writer (seller) of a put is long on the underlying asset but short on the put option itself. To be precise, the seller anticipates the option to become valueless by a rise in the price of the underlying asset above the strike price. By and large, a put option that is purchased is called as a\u00a0long put\u00a0and a put option that is sold is called as a\u00a0short put.<\/p>\n

A\u00a0naked put, also referred to as uncovered put, is a put option whose writer (the seller) does not have a position in the underlying\u00a0security\u00a0or any other instrument. This strategy is best employed by investors who hope to accumulate a position in the underlying stock, but as long as the price is low enough. If the buyer is not able to exercise the options, then the writer keeps the option premium as a “gift” for playing the game.<\/p>\n

If the underlying stock’s market price is under the option’s\u00a0strike price\u00a0when expiration nears, the option owner (buyer) can exercise the put option, prompting the writer to buy the underlying stock at the strike price. This lets the exerciser (buyer) to obtain gains from the difference between the stock’s market price and the option’s strike price.<\/p>\n

But if the stock’s market price is over the option’s strike price at the end of maturity day, the option expires valueless, and the owner’s loss is restricted to the premium (fee) paid for it (the writer’s profit).<\/p>\n

The seller’s potential loss on a naked put can be considerable. If the stock drops all the way to zero (bankruptcy), his loss is equal to the strike price (at which he should buy the stock to cover the option) less the premium received. The potential advantage is the premium obtained when selling the option: if the stock price is over the strike price at expiration, the option seller holds the premium, and the option expires valueless. During the option’s life span, if the stock falls down, the option’s premium may rise (depending on how far the losses stretch (stock\u2019s price) and how much time passes.<\/p>\n

If it does, it turn out be more expensive to close the position (repurchase the put, sold earlier), resulting in a loss. If the stock price totally cave in before the put position is closed, the put writer potentially can face massive loss. In order to shield the put buyer from default, the put writer is obliged to post\u00a0margin. The put buyer does not require posting margin because the buyer would not use the option if it had a negative payoff.<\/p>\n

Example of put option on stock<\/p>\n

A buyer hopes the price of a stock will decline. He pays a premium which he will on no account get back, except it is sold before it expires. The buyer has the right to sell the stock at the strike price.<\/p>\n

Writing a put<\/p>\n

The writer will get a premium from the buyer. If the buyer exercises his option, the writer will purchase the stock at the strike price. If the buyer fails to exercise his option, the writer’s profit is the premium.<\/p>\n