Put (Option Contract) - Explained
What is a Put?
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Table of ContentsWhat is a Put?How Does a Put Work?Puts and CallsExample of a Put OptionWhat is Time Decay?An Example of a Long Put OptionAn Example of a Short Put OptionExercising Put Options
What is a Put?
In an option contract, a put refers to a position in the contract that gives the owner the right to sell the underlying asset or security at the specified price, known as strike price within a set time. The owner of a put option is also known as the buyer, this is the party that has the right but not the obligation to sell the underlying asset. The price at which the buyer sells the underlying asset is a predetermined price reached before the exercise date. Once the owner or buyer of a put option decides to exercise his right to sell the underlying security, the seller or writer of the option contract is forced to purchase the security.
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How Does a Put Work?
A put option can have diverse underlying securities including commodities, stocks, currencies, and bonds. Buyers or owners of put options buy the option with the expectation that the value of the underlying security will decline below its exercise price before its expiration date. Taking such a position in a put option allows the buyer to exercise the right but not the obligation to sell the asset at a specific price. Usually, in a put option, the value of the contract rises when the underlying asset declines in value, hence, the buyer of this option benefits from the decline in the value of the asset.
Puts and Calls
A call option is the opposite of a put option. Both put and call options are derivative contracts in the sense that their price movement is in the direction of the underlying asset. Put options and call options can be used for the trade of securities or assets, including stocks, bonds, and currencies. In a call option, for instance, the holder of the option can exercise the right and not the obligation to buy a stock at a certain price before the expiration date. Traders of call option enter this position with the hope that the price of the underlying asset will increase within a period of time. In a put option, on the contrary, the holder expects to profit from the option when there is a decline in the price of the underlying asset.
Example of a Put Option
The illustration below will help you understand a put option better; An investor buyers a put option covering a number of shares of 100 with the belief that the shares will decline in value over a period of time. The exercise price of the underlying securities is $1.5 per share, making it a total of $150 for 100 shares. If the current price of the asset is $1.2 per share, the investor can decide to exercise the right but not the obligation to sell the assets. Here are some important points you should know about a put option;
- A put option, simply put is a contract that gives a buyer or an owner the right but not the obligation to sell an underlying asset at a specific time before the expiration date.
- Investors or traders that buy put options anticipate a decline in the price of the underlying asset at a specific time.
- A put option increases in value when the price of the underlying asset declines and this contract decreases in value when the price of the underlying asset increase.
What is Time Decay?
A Put Option decreases in value as it approaches its expiry date. The more the time lapses, the higher the probability of the value of the underlying asset increasing in relation to the strike value. The difference between the strike price and the underlying stock price is called the intrinsic value of the Put Option.
- Loss of time value leaves the Put Option with the intrinsic value, which is called being In The Money (ITM).
- Options Out of The Money (OTM) and At The Money (ATM), do not have an intrinsic value rending the Put Options useless, as the strike price is undesirable and the sale would be lossy.
The predetermined premium at which the Put Option is agreed upon is reflected in its Time Value. If the value of a Put Option is $40 while the underlying asset is being traded at $34, the intrinsic value of the Put Option is $6. If this Put Option ends up being traded at a value higher than $6, say $8, the extra $2 is considered its Time Value. These are variable values that fluctuate with the value of the underlying stock options.
An Example of a Long Put Option
If an investor owns a Put Option with a strike price of $10, to be sold in 30 days, with a premium of $1 per share, the investor can sell the shares at the higher price of $10 per share only until the expiration date. If, within the duration of these 30 days, the value of the underlying assets depreciates to $5, the investor will be able to buy the shares at a reduced cost, considerably increasing his profit margins. The more the value of the underlying assets falls compared to the strike price of $10, the higher the profits.
An Example of a Short Put Option
A Short Put Option, a.k.a a Written Option requires taking delivery for the purchase of underlying stocks. If the outlook on a stock is bullish, and it is trading at $50 in the market with a stop loss value of $47 for the next 30 days, an investor can enter a Short Put Option to buy the shares of this stock at a specified premium with the strike rate of $47. If the value of these shares stays above $47, the investor collects the total premium price equal to the maximum profits possible, even as the Put Option expires after 30 days. Conversely, if the value of these shares falls below the $47 level, the investor would incur losses as hes still obligated to purchase the stipulated number of shares at the strike rate of $47.
Exercising Put Options
Writers and buyers aren't obligated to hold on to Put Options until their expiry. The right to sell the Put Option can be exercised anytime within the stipulated period either to lock in maximum profits in the ITM stage, or cut losses during OTM and ATM stages.Option Writers can similarly buy back shares of Options that are performing poorly to avoid heavy losses.