Put Option

Define in Detail

A put option is a type of financial derivative that provides the buyer the pre-emptive right, but not the obligative responsibility, to sell a specific quantity of an underlying security (such as stocks, bonds, commodities, or indices) at a stated price within a predetermined time period. The stated price at which the sale can occur is termed the strike price. The buyer of a put option profits if the price of the underlying security falls below the strike price before the option expires.

Options are essential components in risk management and hedging strategies. Put options are employed to guard against potential declines in asset prices, offering a form of insurance for the holders.

Examples

Protective Put: An investor owns shares of a company currently trading at $50 each. Fearing a potential drop in price, the investor purchases a put option with a strike price of $48 expiring in three months. If the stock’s price falls to $40, the investor can exercise the put option and sell shares at $48, mitigating the loss.
Speculative Put: A trader who believes that a particular company’s stock, currently trading at $100, will decline. The trader buys a put option with a $95 strike price. If the stock then drops to $85, the trader can exercise the put, buying the stock at market price and selling it at the higher strike price of $95, thereby making a profit.

Frequently Asked Questions (FAQs)

What is the main difference between a put option and a call option?

A put option gives the owner the right to sell the underlying asset at a specific price, while a call option gives the owner the right to buy the underlying asset at a specific price.

How does the price of a put option (premium) get determined?

The price of a put option, or the premium, is determined by several factors, including the underlying asset’s current price, the strike price, the time remaining until the expiration date, the volatility of the underlying asset, and the risk-free interest rate.

Can a put option expire worthless?

Yes, a put option can expire worthless if the price of the underlying asset is higher than the strike price at the time of expiration. In such cases, the option holder has no incentive to exercise the option.

What strategies use put options?

Strategies such as protective puts, bear put spreads, and synthetic long puts involve the use of put options. These strategies are used for hedging and market speculation.

Are put options suitable for beginners?

Put options can be complex and entail a risk of loss, especially for novice investors. Beginners should thoroughly educate themselves or consult with a financial advisor before trading options.

Option Premium: The price paid by the buyer to the seller for the rights granted by the option.
Strike Price (Exercise Price): The specified price at which the put option buyer can sell the underlying asset.
Expiration Date: The last date on which the option can be exercised.
Underlying Asset: The financial asset on which the option contract is based.
In the Money (ITM): A situation where exercising the option would be profitable (current price < strike price for puts).
Hedging: Risk management strategies that use financial instruments to offset potential losses.

Online References

Suggested Books for Further Studies

“Options, Futures, and Other Derivatives” by John C. Hull
“Options as a Strategic Investment” by Lawrence G. McMillan
“Fundamentals of Futures and Options Markets” by John C. Hull
“The Options Playbook” by Brian Overby
“Option Volatility and Pricing” by Sheldon Natenberg

Accounting Basics: “Put Option” Fundamentals Quiz

### A put option gives the holder the right to: - [ ] Buy the underlying asset at a set price. - [x] Sell the underlying asset at a set price. - [ ] Both buy and sell the underlying asset at a set price. - [ ] None of the above. > **Explanation:** A put option gives the holder the right to sell the underlying asset at a specified price within a defined period. ### What is the term for the price at which a put option holder can sell the underlying asset? - [ ] Market price - [ ] Premium - [x] Strike price - [ ] Intrinsic price > **Explanation:** The price at which the put option holder can sell the underlying asset is called the strike price or exercise price. ### A put option is considered 'in-the-money' (ITM) when: - [ ] The underlying asset's price is above the strike price. - [x] The underlying asset's price is below the strike price. - [ ] The underlying asset's price is equal to the strike price. - [ ] The option’s expiration date has passed. > **Explanation:** A put option is 'in-the-money' when the current price of the underlying asset is lower than the strike price. ### One main function of a put option is: - [ ] To hedge against rising asset prices. - [ ] To guarantee dividends. - [x] To hedge against falling asset prices. - [ ] To lock in a purchase price. > **Explanation:** Put options are used to hedge against potential declines in asset prices, offering protection to the holder. ### The amount the buyer pays to acquire a put option is known as: - [ ] Intrinsic value - [ ] Strike price - [x] Premium - [ ] Dividend > **Explanation:** The premium is the price paid by the buyer to the seller for acquiring the put option. ### What happens to a put option if it expires in-the-money (ITM)? - [ ] It becomes worthless. - [x] It can be exercised for a profit. - [ ] The buyer pays another premium. - [ ] It transfers to another holder. > **Explanation:** If a put option expires in-the-money, it can be exercised, allowing the buyer to sell the underlying asset at the higher strike price for a profit. ### What measure determines the number of days until an option expires? - [ ] Delta - [ ] Theta - [ ] Rho - [x] Time to expiration > **Explanation:** The time to expiration measures the number of days remaining until the option expires. Option premiums are partially influenced by this factor. ### Put options are often used by investors to: - [ ] Increase dividends from stocks. - [x] Hedge against potential declines in the value of assets. - [ ] Raise the value of underlying assets. - [ ] Decrease the market volatility. > **Explanation:** Investors use put options to hedge against potential declines in the price of the underlying assets, safeguarding their investments. ### The difference between the strike price and the current market price of the underlying asset in a put option is known as: - [ ] Delta - [x] Intrinsic value - [ ] Gamma - [ ] Volatility > **Explanation:** The intrinsic value of a put option is the difference between the strike price and the market price of the underlying asset, if the put option is in-the-money. ### Which factor would increase the price (premium) of a put option? - [ ] Decreased volatility of the underlying asset - [ ] Less time to expiration - [x] Higher volatility of the underlying asset - [ ] Lower strike price > **Explanation:** Higher volatility of the underlying asset increases the likelihood of the asset price falling below the strike price, thus increasing the put option’s premium due to higher potential payouts.

Thank you for exploring the intricate details of put options and taking our quiz on the fundamentals. Continue honing your financial knowledge to excel in the dynamic world of trading!