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Monday, April 16, 2007

What is Put Option?

Put option is a contract that gives the buyer of the options the right to sell the underlying security at a particular price (i.e. strike price) on or before a certain date (i.e. expiration date).
The seller (or writer) is, in turn, obligated to buy the security should the buyer chooses to exercise the option.

Put option’s price increases when the underlying stock’s price decreases, and decreases as the underlying stock’s price increases (negative relationship).
As such, we will buy a Put Option if we think that a stock will move downwards.

Example:
Using the above Company ABC example, if you anticipate the stock to drop from $23 per share, you can buy a Put option for $90 (or $0.9 per share) that gives you the right to sell 100 shares of ABC at $22.5 per share anytime in the next 90 days.

If the stock falls to $20 per share before option’s expiration:
1) You can, in theory, buy 100 shares in the open market for $20 per share and then exercise your put option which gives you the right to sell the stock at $22.5 per share. Your profit will be $1.6 per share (22.5 – 20 = 2.5 – 0.9 for option premium = $1.6 per share).

2) In practice, you would just sell your put option, which would now have a value of at least $2.5 per share (intrinsic value only) and profit by $1.6 per share (2.5 – 0.9 for option premium = $1.6 per share).

2 comments:

Anonymous said...

An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset (a stock or index) at a specific price on or before a certain date (listed options are all for 100 shares of the particular underlying asset). Alexander Shlepakov
Options are derivatives, unlike stocks
(i.e, options derive their value from
something else, the underlying security).
Options have expiration dates, while stocks
do not.
There is not a fixed number of options, as
there are with stock shares available.
Stockowners have a share of the company,
with voting and dividend rights. Options
convey no such rights.

OPTIONS TRADING BEGINNER said...

Hi Anon,
Thanks for the valuable additional info! :)

Regards,
OTB