What Is a Put?
A put is an options contract that gives the owner the right, but not the obligation, to sell a certain amount of the underlying asset, at a set price within a specific time. The buyer of a put option believes that the underlying stock will drop below the exercise price before the expiration date. The exercise price is the price that the underlying asset must reach for the put option contract to hold value.
The Basics of Put Options
Puts are traded on various underlying assets, which can include stocks, currencies, commodities, and indexes. The buyer of a put option may sell, or exercise, the underlying asset at a specified strike price.
The value of a put option appreciates as the price of the underlying stock depreciates relative to the strike price. On the flip side, the value of a put option decreases as the underlying stock increases. A put option's value also decreases as its expiration date approaches.
The possible payoff for a holder of a put is illustrated in the following diagram:
What is a Put?
- A put gives the owner the right, but not the obligation, to sell the underlying stock at a set price within a specified time.
- A put option's value goes up as the underlying stock price depreciates; the put option's value goes down as the underlying stock appreciates.
- When an investor purchases a put, she expects the underlying stock to decline in price.
Reviewing Puts and Calls
Derivatives are financial instruments that derive value from price movements in their underlying assets, which can be a commodity such as gold or stock. Derivatives are largely used as insurance products to hedge against the risk that a particular event may occur. The two main types of derivatives used for stocks are put and call options.
A call option gives the holder the right, but not the obligation, to buy a stock at a certain price in the future. When an investor buys a call, she expects the value of the underlying asset to go up.
A put option gives the holder the right, but not the obligation, to sell a stock at a certain price in the future. When an investor purchases a put, she expects the underlying asset to decline in price; she may sell the option and gain a profit. An investor can also write a put option for another investor to buy, in which case, she would not expect the stock's price to drop below the exercise price.
Example—How Does a Put Option Work?
An investor purchases one put option contract on ABC company for $100. Each option contract covers 100 shares. The exercise price of the shares is $10, and the current ABC share price is $12. This put option contract has given the investor the right, but not the obligation, to sell 100 shares of ABC at $10.
If ABC shares drop to $8, the investor's put option is in the money (ITM)—which means that the strike price is below the market price of the underlying asset—and she can close her option position by selling the contract on the open market.
On the other hand, she can purchase 100 shares of ABC at the existing market price of $8, and then exercise her contract to sell the shares for $10. Disregarding commissions, the profit for this position is $200, or 100 x ($10 - $8). Remember that the investor paid a $100 premium for the put option, giving her the right to sell her shares at the exercise price. Factoring in this initial cost, her total profit is $200 - $100 = $100.
As another way of working a put option as a hedge, if the investor in the previous example already owns 100 shares of ABC company, that position would be called a married put and could serve as a hedge against a decline in the share price.