A:

A put option is a contract that gives the option holder the right, but not obligation, to sell a set amount of shares (100 shares per contract) at a set price. If the option is exercised, the option writer must purchase the shares from the option holder.

[Put and call options are the two fundamental tools for option trading. If you're new to option trading, Investopedia's Options for Beginners Course will show you the mechanics of options and how they can be used for both hedging and speculation, with over five hours of on-demand video, exercises, and interactive content.]

The opposite of a put option is a call option, which gives the holder the right to purchase a set amount of shares at a set price. Whether a put or a call option, however, the option holder can exercise or act on the contract at any time (American option) until its expiration date.

If the holder wants to exercise the contract, he or she simply lets the broker know of the intent to exercise. For example, if Max purchases one March $10 put option on Ford Motor Co., it gives him the right to sell 100 shares of Ford at $10 before the expiration date in March, which usually falls on the third Friday. If Max already holds 100 shares of Ford, his broker will simply sell these shares at the $10 price. In this case, Max would realize a gain if the current price for which he could sell the Ford shares in the market was below the $10 exercise price. For example, if, after Max has purchased the put option, shares fall to $5, he would still be able to sell 100 shares at $10 ($1,000) instead of the $500 ($5 x 100) for which he could currently sell the shares in the market. This transaction would represent an economic gain of $500 for Max.

Now let's assume that Max does not have shares of Ford Motor Co. in his account and he notifies his broker that he wants to exercise the option. Max's broker could then purchase 100 shares of Ford at $5 and sell them at $10. In this case, Max would also receive a gain of $500 on the option.

The other alternative to exercising an option is to simply sell the option back to the market. If Max chooses this route, the price he would receive in the market would be equivalent to the gain of exercising. In this case, each option would sell for $5, which would cost a purchaser $500 - this price is determined by the price of the option times the shares it controls ($5 x 100).

To learn more, see Options Basics and Trading A Stock Versus Stock Options - Part 1.

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