Put Options Easy to Understand
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What is a Put Option? A put option gives the holder of the stock the right, but not the obligation to sell the underlying asset at specific price during a preset period of time. When you have the right to sell an option, the other party to the transaction has the obligation to buy. That is why it is called a put because you are "putting" the asset into the hands of the stocks seller at the agreed upon exercise price. This causes the option to increase in value as the price of the asset drops. Let's take a look at our earlier example of Widgets and Co to see how a put option works and why it gains value when the underlying asset price drops. It is January 2012.You know that the stock market has shown an extremely powerful seasonal tendency to drop during January and April. Because Widgets and Co shares tend to rise and fall with the market, you want to own a stock that rises in value when the market falls. You want to own a put option. Widgets and Co is trading at 100 in January. You want to acquire the right to sell Widgets a Co shares if they drop in value, so you buy an option with a strike price of 100 and an expiration date of April18. Remember, the strike price is the price at which the option can be exercised. This means that you will have the right to sell Widgets and Co shares at 100 before the April options expire on April 18, no matter how high or how low Widgets and Co shares are. The seller of the put option, who will be obliged to buy from you the shares of Widgets and Co if you want to sell, requires compensation for giving you the right to sell Widgets and Co to him at 100. The compensation you give him (e.g. the price of the stock you pay) is called the option premium. The price of the option in January is 3. Now let's fast forward to April. Let's look at what it will be worth as Widgets and Co shares fluctuate. Remember, the April put option with a strike price of 100 gives you the right but not the obligation to sell Widgets and Co shares at 100 before April 18. If Widgets and Co shares are trading at 80 on the New York Stock Exchange here's what would happen. You would have the right to sell the stock to the person who sold you the option. The price at which you would sell Widgets and Co put option would be the exercise price of 100. Remember, the person who sells the put option has the obligation to buy it from you at the preset price. Therefore, you could buy the stock in the open market at 80 and immediately sell it to the grantor at 100, as is your right under the option. By buying Widgets and Co at 80 and immediately selling it for 100, your net is 20. Therefore, the exercise value of a put option with strike price of 100 is 20 when the asset is at 80. What about when Widgets and Co is at 90? You could buy the stock at 90 in the open market, and exercise your right to sell the stock to the option grantor at 100. When you buy at 90 and sell at 100, you earn 10, which is the put option's value. How about if Widgets and Co is trading at 100? In this case, it really doesn't matter. You could buy the shares in the open market for 100, and exercise your right to sell them at 100. But that would merely be a break even transaction. At the very least, one could state that there is no added value to exercising the put option, so it is essentially worthless. As with a call option, any option whose exercise price is identical to the current market price is said to be "at-the money". How about if Widgets and Co was at 110? You could exercise your right to put the stock to the option seller. But why would you? If you bought Widgets and Co at 110, your right would be to sell it at 100. And why would anybody buy anything at 110, only to sell it at 100? It automatically locks in a loss of-10. Because you have the right and are not obliged to do this, you would do nothing - the option is worthless. Normally, what happens if Widgets and Co shares go to 120? Your right is to sell Widgets and Co at 100. But Widgets and Co shares are trading at 120. So you would have to pay 120, only to sell the shares at 100, thus locking in loss of -20. Because you have the right and are not obliged to do this the put option is worthless. Here is a plot of the put options intrinsic value: As you can see, the put option increases in value as the underlying asset decreases in value. Let's look at another example, using a commodity. In this case, let's look at soybeans. It is November. Soybeans are trading at 7.00 per bushel. The harvest was a bumper crop. You think soybeans are going to go down during the winter. You buy a March 700 put option. March stands for the expiration month. Remember, in futures options the expiration month corresponds to the expiration of the futures contract, not the option. So in this case, the March expiration corresponds to the March soybean futures expiration. March soybeans options actually expire in February. The exercise price, or strike price, in this instance is 7.00, but it is often abbreviated to 700 on most quote machines and in the financial newspapers. If soybeans were 5.00, would you exercise the put option to sell them at 7.00? Sure thing! You could buy soybeans at 5.00 in the open market and sell them at the agreed upon price of 7.00 to the person who granted you the put option. You would earn 2.00 on the exercise thus 2.00 is the put option's intrinsic value. How about when soybeans are at 6.00, would you exercise your put option yes? You could buy soybeans at 6.00, contact the put option seller and put soybeans into his hands for a price of 7.00. You would earn 1.00 on the exercise. What if soybeans are at 7.00? Maybe. But probably not. After all why bother buying soybeans at 7.00, only to sell them to someone for 7.00? How about 8.00? Absolutely not! Remember, a put gives you the right to sell. In order to exercise your put option, you would have to buy soybeans in the open market at 8.00. Then you would sell them at the agreed upon strike price of 7.00. In this case, you would be buying high (at 8.00) and selling low (at 7.00), locking in a loss of -1.00. But remember, you have the right to sell not the obligation to sell, so you do nothing. Thus the put option is worthless. If soybeans are at 9.00, it's the same thing! In order to exercise your option, you would have to buy soybeans in the open market 9.00. Then you would sell them at the agreed upon strike price of 7.00. In this case, you would be buying high (at 9.00) and selling low (at 7.00), locking in a loss of -2.00. But remember, you have the right to sell not the obligation to sell, so you do nothing. So the put option is worthless. Here is a plot of the put option's intrinsic value. As you can see through these examples, a put's exercise value increases as the price of the underlying asset decreases. It does so by giving the put option holder the right to sell at a predetermined price. When the price of the asset drops, the option holder can buy the asset at the current market price, put the asset into the option grantor's hands (i.e., sell it to the option grantor), and collect the agreed-upon sale price, which is the strike price of the option. Stock & Commodity Trading