Put option 1

Put option
A put option (usually just called a "put") is a financial contract between two parties, the writer (seller) and the buyer
of the option. The buyer acquires a short position by purchasing the right to sell the underlying instrument to the
seller of the option for a specified price (the strike price) during a specified period of time. If the option buyer
exercises their right, the seller is obligated to buy the underlying instrument from them at the agreed upon strike
price, regardless of the current market price. In exchange for having this option, the buyer pays the seller or option
writer a fee (the option premium).
By providing a guaranteed buyer and price for an underlying instrument (for a specified span of time), put options
offer insurance against excessive loss. Similarly, the seller of put options profits by selling options that are not
exercised. Such is the case when the ongoing market value of the underlying instrument makes the option
unnecessary; i.e. the market value of the instrument remains above the strike price during the option contract period.
Purchasers of put options may also profit from the ability to sell the underlying instrument at an inflated price
(relative to the current market value) and repurchase their position at the much reduced current market price.

Instrument models
The terms for exercising the option's right to sell it differ depending on option style. A European put option allows
the holder to exercise the put option for a short period of time right before expiration, while an American put option
allows exercise at any time before expiration.
The most widely-traded put options are on equities, but they are traded on many other instruments such as interest
rates (see interest rate floor) or commodities.
The put buyer either believes that the underlying asset's price will fall by the exercise date or hopes to protect a long
position in it. The advantage of buying a put over short selling the asset is that the option owner's risk of loss is
limited to the premium paid for it, whereas the asset short seller's risk of loss is unlimited (its price can rise greatly,
in fact, in theory it can rise infinitely, and such a rise is the short seller's loss.) The put buyer's prospect (risk) of gain
is limited to the option's strike price less the underlying's spot price and the premium/fee paid for it.
The put writer believes that the underlying security's price will rise, not fall. The writer sells the put to collect the
premium. The put writer's total potential loss is limited to the put's strike price less the spot and premium already
received. Puts can be used also to limit the writer's portfolio risk and may be part of an option spread.
A naked put, also called an uncovered put, is a put option whose writer (the seller) does not have a position in the
underlying stock or other instrument. This strategy is best used by investors who want to accumulate a position in the
underlying stock, but only if the price is low enough. If the buyer fails to exercise the options, then the writer keeps
the option premium as a 'gift' for playing the game.
If the underlying stock's market price is below the option's strike price when expiration arrives, the option owner
(buyer) can exercise the put option, forcing the writer to buy the underlying stock at the strike price. That allows the
exerciser (buyer) to profit from the difference between the stock's market price and the option's strike price. But if
the stock's market price is above the option's strike price at the end of expiration day, the option expires worthless,
and the owner's loss is limited to the premium (fee) paid for it (the writer's profit).
The seller's potential loss on a naked put can be substantial. If the stock falls all the way to zero (bankruptcy), his
loss is equal to the strike price (at which he must buy the stock to cover the option) minus the premium received. The
potential upside is the premium received when selling the option: if the stock price is above the strike price at
expiration, the option seller keeps the premium, and the option expires worthless. During the option's lifetime, if the
stock moves lower, the option's premium may increase (depending on how far the stock falls and how much time
passes). If it does, it becomes more costly to close the position (repurchase the put, sold earlier), resulting in a loss. If
the stock price completely collapses before the put position is closed, the put writer potentially can face catastrophic
Put option 2

loss.

Example of a put option on a stock

Buying a put:
A Buyer thinks price of a stock will decrease.
Pay a premium which buyer will never get back,
unless it is sold before expiration.
The buyer has the right to sell the stock
at strike price.

Writing a put:
Writer receives a premium.
Payoff from buying a put.
If buyer exercises the option,
writer will buy the stock at strike price.
If buyer does not exercise the option,
writer's profit is premium.

• 'Trader A' (Put Buyer) purchases a put contract to sell 100

shares of XYZ Corp. to 'Trader B' (Put Writer) for $50/share.
The current price is $55/share, and 'Trader A' pays a premium of
$5/share. If the price of XYZ stock falls to $40/share right before
expiration, then 'Trader A' can exercise the put by buying 100
shares for $4,000 from the stock market, then selling them to
Payoff from writing a put.
'Trader B' for $5,000.

Trader A's total earnings (S) can be calculated at $500.

Sale of the 100 shares of stock at strike price of $50
to 'Trader B' = $5,000 (P)
Purchase of 100 shares of stock at $40 = $4,000 (Q)
Put Option premium paid to Trader B for buying the contract of
100 shares @ $5/share, excluding commissions = $500 (R)

S=P-(Q+R)=$5,000-($4,000+$500)=$500

• If, however, the share price never drops below the strike price (in this case, $50), then 'Trader A' would not
exercise the option. (Why sell a stock to 'Trader B' at $50, if it would cost 'Trader A' more than that to buy it?).
Trader A's option would be worthless and he would have lost the whole investment, the fee (premium) for the
option contract, $500 (5/share, 100 shares per contract). Trader A's total loss are limited to the cost of the put
premium plus the sales commission to buy it.
A put option is said to have intrinsic value when the underlying instrument has a spot price (S) below the option's
strike price (K). Upon exercise, a put option is valued at K-S if it is "in-the-money", otherwise its value is zero. Prior
to exercise, an option has time value apart from its intrinsic value. The following factors reduce the time value of a
put option: shortening of the time to expire, decrease in the volatility of the underlying, and increase of interest rates.
Option pricing is a central problem of financial mathematics.
Put option 3

See also
• Call option
• CBOE S&P 500 PutWrite Index (PUT)
• Married put

Options
• Credit default option
• Interest rate cap and floor
• Options on futures
• Real option

External links
• Basic Options Concepts: Put Options [1] - at Yahoo! Finance

References
[1] http:/ / biz. yahoo. com/ opt/ basics4. html
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