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 the strike price before the expiry date. If the option is exercised, the option writer must purchase the shares from the option holder. "Exercising" means the option buyer is taking advantage of their right to sell the shares at the strike price.

[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 the strike price prior to expiration.

There are a number of ways to close out the option trade, depending on the circumstance.

If the option expires in the money, the option will be exercised in the ways discussed below. If the option expires out of the money, nothing happens, and the premium paid for the option is lost. Exercising an option before expiry requires letting the broker know you want to exercise the option early.

If Max purchases one $11 put option on Ford Motor Co. (F), it gives him the right to sell 100 shares of Ford at $11 before the expiration date.

If Max already holds 100 shares of Ford, his broker will sell these shares at the $11 strike price. An option writer will need to purchase those shares at that price.

Max realizes a gain on the option if the price of Ford is below the $11 strike price. If, after Max purchases the put option, the share price falls to $8, he would be able to sell 100 shares at $11 instead of the current $8 market price. By buying the option, Max saves himself $300 (less the cost of the option), as he can sell 100 shares at $11, and make $1,100, instead of having to sell the shares at $8 for $800. Max could have also sold his stock at $11, and not bought a put option. This is also reasonable, yet possibly he thought the stock price could rise so he didn't want to sell the stock, but he did want protection incase the stocked dropped and so he was willing to pay the option premium for that protection.

Now let's assume that Max does not have shares of Ford, but has bought the $11 put and the stock currently trades at $8. Just prior to expiration (or when he wants to exercise) he could purchase shares of Ford at $8 and then have the broker exercise the option at $11. This would net Max $300, less the cost of the option premium,fees, and commissions

If Max doesn't own shares, the option can be exercised to initiate a short position in the stock. Since max doesn't own any shares to sell, the put option will initiate a short position at $11. He can then cover the short position at the current market price of $8, or continue to hold the short position. Initiating a short position requires a margin account, and capital within the account to cover the margin on the short trade.

The other alternative to exercising an option is to simply sell the option back to the market. This is the simplest approach, and is how most option trades are closed. There is no exchange of shares, rather the trader simply makes money off the change in the option price. For example, the $11 put may have cost $0.65 x 100 shares, or $65 (plus commissions). Two months later the option is about to expire and the stock is trading at $8. Most of the time value of the option will be eroded, but it still has intrinsic value ($3), so the option may be priced at $3.10. Max bought his option for $65 and can now sell it for $310. In the scenarios above, you add in the cost of the option ($65, in this case) to see the net advantage from exercising the option.

Option premiums are in constant flux, and purchasing put options that are deep in the money or far out of the money drastically affect the option premium and the possibility of being able to exercise (if desired).

Closing out a put trade by simply selling the put is popular because most brokers charge higher fees for exercising an option compared to the commission for selling an option. Before exercising an option, see how much your broker charges to do so. This could have a material impact on profits, especially on smaller trades.

To learn more, see Options Basics.

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