What is a 'Put Option'
A put option is an option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time. This is the opposite of a call option, which gives the holder the right to buy shares.
BREAKING DOWN 'Put Option'A put option becomes more valuable as the price of the underlying stock depreciates relative to the strike price. Conversely, a put option loses its value as the underlying stock increases and the time to expiration approaches.
The value of a put option decreases due to time decay, because the probability of the stock falling below the specified strike price decreases. When an option loses its time value, the intrinsic value is left over, which is equivalent to the difference between the strike price less the stock price. Out-of-the-money and at-the-money put options have an intrinsic value of zero because there would be no benefit of exercising the option. Investors could sell short the stock at the current market price, rather than exercising an out-of-the-money put option at an undesirable strike price, which would produce losses.
Long Put Option Example
For example, assume an investor owns one put option on hypothetical stock TAZR with a strike price of $25 expiring in one month. Therefore, the investor has the right to sell 100 shares of TAZR at a price of $25 until the expiration date next month, which is usually the third Friday of the month. If shares of TAZR fall to $15 and the investor exercises the option, the investor could purchase 100 shares of TAZR for $15 in the market and sell the shares to the option's writer for $25 each. Consequently, the investor would make $1,000 (100 x ($25-$15)) on the put option. Note that the maximum amount of potential profit in this example ignores the premium paid to obtain the put option.
Short Put Option Example
Contrary to a long put option, a short put option obligates an investor to take delivery, or purchase shares, of the underlying stock. Assume an investor is bullish on hypothetical stock FAB, which is currently trading at $42.50, and does not believe it will fall below $35 over the next two weeks. The investor could collect a premium by writing one put option on FAB with a strike price of $35 for $1.50. Therefore, the investor would collect a total of $150, or $1.50 * 100. If FAB closes above $35, the investor would keep the premium collected since the options would expire out of the money and be worthless. Conversely, if FAB closes below $35, the investor must purchase 100 shares of FAB at $35, due to the contractual obligation.