What Is a Put?
A put is an option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying asset at a set price within a specified time. The buyer of a put option believes the underlying asset will drop below the exercise price before the expiration date. The exercise price is the price the underlying asset must reach for the put option contract to hold value.
The Basics of a Put
Put options are contracts traded on various underlying assets. These may include stocks, currencies, commodities and indexes. The put option buyer can sell at a specified price, or the strike price. This is the price at which a derivative contract can be exercised.
The value of a put option increases as the price of the underlying stock depreciates relative to the strike price. On the flip side, a put option loses value as the underlying stock appreciates. Its value also decreases as the expiration date approaches.
The possible payoff for a holder of a put option contract is illustrated by the following diagram:
Puts and Calls
There are two main types of derivatives used for stocks: put and call options. Derivatives are financial instruments that derive value from price movements in the underlying asset. The underlying asset can be a commodity such as gold or a stock. Derivatives are largely used as insurance products to hedge against the risk of a particular event occurring.
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 is the opposite. When an investor purchases a put, she expects the underlying asset to decline in price. The investor then profits by selling the put option at a profit or exercising the option. An investor can also write a put option for another investor to buy. If an investor writes a put contract, she does not expect the stock's price to drop below the exercise price.
Example of a Put Option
Each option contract covers 100 shares. With that in mind, consider the investor who purchases one put option contract on ABC company for $100. 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 – which means 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 also that the options buyer paid $100 premium for the put, giving her the right to sell her shares at the exercise price. Factoring in this initial cost, her total profit is $200 - $100 = $100.
There are other ways to work a put option as a hedge. If the investor in the previous example already owns 100 shares of ABC company, it is referred to as a "married put" position and serves as a hedge against a decline in share price.