Put option
A put option is a financial contract between two parties, the buyer and the seller of the option. The put allows the buyer the right but not the obligation to sell a commodity or financial instrument (the underlying instrument) to the seller of the option at a certain time for a certain price (the strike price). The seller assumes the corresponding obligations.
Note that the seller of the option undertakes to buy the underlying! In exchange for being granted this option, the buyer pays the seller a fee.
Exact specifications may differ depending on option style. A european put option allows the holder to exercise, i.e. to sell, on the delivery date only. An american put option allows exercise at any time during the life of the option.
The most widely-known put option is the stock option, the option to sell stock in a particular company. However, options are traded on many other assets: financial - such as interest rates (see interest rate floor) - and physical, such as gold or crude oil.
Example of a put option on a stock
- I enter a contract to have the option to sell a share in XYZ Corp. on June 1, 2003, for $50.
- If the XYZ Corp. share price is actually only $40 on that day, then I would exercise my option (i.e. sell the share from the counter-party). I could then buy another share in the open market for $40, i.e. the option would be worth $10; my profit would be $10 minus the fee I paid for the option.
- If, however, the share price is more than the option price, say, $60, then I would not exercise the option. If I really wanted to sell such a share, I could do so in the open market for $60, and make more profit than I would by selling through the option. My option would be worthless and I would have lost my whole investment, the fee for the option.
- Thus, in any future state of the world, I am certain not to lose money by owning the option; my loss is limited to the fee I have paid.
This example illustrates that the put option has positive monetary value when the underlying instrument has a spot price (S) below the strike price (K). Since the option will not be exercised unless it is "in-the-money", the payoff for a put option is
- Max[ (K-S) ; 0 ] or formally, <math>(K-S)^{+}<math>
- where <math>(x)^+ =\{^{x\ if\ x\geq 0}_{0\ otherwise}<math>
Prior to exercise, the option value, and therefore price, varies with the underlying price and with time. The put price must reflect the "likelihood" or chance of the option "finishing in-the-money". The price should thus be higher with more time to expiry, and with a more volatile underlying instrument. The science of determining this value is the central tenet of financial mathematics. The most common method is to use the Black-Scholes formula. Whatever the formula used, the buyer and seller must agree this value initially.
Related: Moneyness, Option time value, Call option, Put-call parity
See also: Derivatives markets, Derivative security, Financial economics, Futures, List of finance topics
Options: Stock option, Warrants, Foreign exchange option, Interest rate options , Bond options, Options on futures, Swaption, Interest rate cap, Interest rate floor, Exotic interest rate option, Credit default option, binary option, real option
