Put option

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In finance, a put or put option is a stock market device which gives the owner the right, but not the obligation, to sell an asset (the underlying), at a specified price (the strike), by a predetermined date (the expiry or maturity) to a given party (the seller of the put). The purchase of a put option is interpreted as a negative sentiment about the future value of the underlying stock. [1] The term "put" comes from the fact that the owner has the right to "put up for sale" the stock or index.

Contents

Put options are most commonly used in the stock market to protect against the decline of the price of a stock below a specified price. If the price of the stock declines below the specified price of the put option, the owner/buyer of the put has the right, but not the obligation, to sell the asset at the specified price, while the seller of the put has the obligation to purchase the asset at the strike price if the owner uses the right to do so (the owner/buyer is said to exercise the put or put option). In this way the buyer of the put will receive at least the strike price specified, even if the asset is currently worthless.

If the strike is K, and at time t the value of the underlying is S(t), then in an American option the buyer can exercise the put for a payout of K-S(t) any time until the option's maturity time T. The put yields a positive return only if the security price falls below the strike when the option is exercised. A European option can only be exercised at time T rather than any time until T, and a Bermudan option can be exercised only on specific dates listed in the terms of the contract. If the option is not exercised by maturity, it expires worthless. (The buyer will not exercise the option at an allowable date if the price of the underlying is greater than K.)

The most obvious use of a put is as a type of insurance. In the protective put strategy, the investor buys enough puts to cover his holdings of the underlying so that if a drastic downward movement of the underlying's price occurs, he has the option to sell the holdings at the strike price. Another use is for speculation: an investor can take a short position in the underlying stock without trading in it directly.

A protective put, or married put, is a portfolio strategy where an investor buys shares of a stock and, at the same time, enough put options to cover those shares. In equilibrium this strategy will have the same net payoff as buying a call option.

Puts may also be combined with other derivatives as part of more complex investment strategies, and in particular, may be useful for hedging. By put-call parity, a European put can be replaced by buying the appropriate call option and selling an appropriate forward contract.

Hedge (finance)

A hedge is an investment position intended to offset potential losses or gains that may be incurred by a companion investment. A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, gambles, many types of over-the-counter and derivative products, and futures contracts.

Call option company

A call option, often simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right, but not the obligation, to buy an agreed quantity of a particular commodity or financial instrument from the seller of the option at a certain time for a certain price. The seller is obligated to sell the commodity or financial instrument to the buyer if the buyer so decides. The buyer pays a fee for this right. The term "call" comes from the fact that the owner has the right to "call the stock away" from the seller.

Forward contract non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed upon today

In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or to sell an asset at a specified future time at a price agreed upon today, making it a type of derivative instrument. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into.

Instrument models

The terms for exercising the option's right to sell it differ depending on option style. A European put option allows the holder to exercise the put option for a short period of time right before expiration, while an American put option allows exercise at any time before expiration.

In finance, the style or family of an option is the class into which the option falls, usually defined by the dates on which the option may be exercised. The vast majority of options are either European or American (style) options. These options—as well as others where the payoff is calculated similarly—are referred to as "vanilla options". Options where the payoff is calculated differently are categorized as "exotic options". Exotic options can pose challenging problems in valuation and hedging.

The most widely traded put options are on stocks/equities, but they are traded on many other instruments such as interest rates (see interest rate floor) or commodities.

Stock financial instrument

The stock of a corporation is all of the shares into which ownership of the corporation is divided. In American English, the shares are commonly known as "stocks". A single share of the stock represents fractional ownership of the corporation in proportion to the total number of shares. This typically entitles the stockholder to that fraction of the company's earnings, proceeds from liquidation of assets, or voting power, often dividing these up in proportion to the amount of money each stockholder has invested. Not all stock is necessarily equal, as certain classes of stock may be issued for example without voting rights, with enhanced voting rights, or with a certain priority to receive profits or liquidation proceeds before or after other classes of shareholders.

Interest rate percentage of a sum of money charged for its use

An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited or borrowed. The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, the compounding frequency, and the length of time over which it is lent, deposited or borrowed.

The put buyer either believes that the underlying asset's price will fall by the exercise date or hopes to protect a long position in it. The advantage of buying a put over short selling the asset is that the option owner's risk of loss is limited to the premium paid for it, whereas the asset short seller's risk of loss is unlimited (its price can rise greatly, in fact, in theory it can rise infinitely, and such a rise is the short seller's loss). The put buyer's prospect (risk) of gain is limited to the option's strike price less the underlying's spot price and the premium/fee paid for it.

The put writer believes that the underlying security's price will rise, not fall. The writer sells the put to collect the premium. The put writer's total potential loss is limited to the put's strike price less the spot and premium already received. Puts can be used also to limit the writer's portfolio risk and may be part of an option spread.

The put buyer/owner is short on the underlying asset of the put, but long on the put option itself. That is, the buyer wants the value of the put option to increase by a decline in the price of the underlying asset below the strike price. The writer (seller) of a put is long on the underlying asset and short on the put option itself. That is, the seller wants the option to become worthless by an increase in the price of the underlying asset above the strike price. Generally, a put option that is purchased is referred to as a long put and a put option that is sold is referred to as a short put.

A naked put, also called an uncovered put, is a put option whose writer (the seller) does not have a position in the underlying stock or other instrument. This strategy is best used by investors who want to accumulate a position in the underlying stock, but only if the price is low enough. If the buyer fails to exercise the options, then the writer keeps the option premium. If the underlying stock's market price is below the option's strike price when expiration arrives, the option owner (buyer) can exercise the put option, forcing the writer to buy the underlying stock at the strike price. That allows the exerciser (buyer) to profit from the difference between the stock's market price and the option's strike price. But if the stock's market price is above the option's strike price at the end of expiration day, the option expires worthless, and the owner's loss is limited to the premium (fee) paid for it (the writer's profit).

The seller's potential loss on a naked put can be substantial. If the stock falls all the way to zero (bankruptcy), his loss is equal to the strike price (at which he must buy the stock to cover the option) minus the premium received. The potential upside is the premium received when selling the option: if the stock price is above the strike price at expiration, the option seller keeps the premium, and the option expires worthless. During the option's lifetime, if the stock moves lower, the option's premium may increase (depending on how far the stock falls and how much time passes). If it does, it becomes more costly to close the position (repurchase the put, sold earlier), resulting in a loss. If the stock price completely collapses before the put position is closed, the put writer potentially can face catastrophic loss. In order to protect the put buyer from default, the put writer is required to post margin. The put buyer does not need to post margin because the buyer would not exercise the option if it had a negative payoff.

Example of a put option on a stock

Payoff from buying a put. Long put option.svg
Payoff from buying a put.
Payoff from writing a put. Short put option.svg
Payoff from writing a put.

Buying a put

A buyer thinks the price of a stock will decrease. He pays a premium which he will never get back, unless it is sold before it expires. The buyer has the right to sell the stock at the strike price.

Writing a put

The writer receives a premium from the buyer. If the buyer exercises his option, the writer will buy the stock at the strike price. If the buyer does not exercise his option, the writer's profit is the premium.

Trader A's total earnings (S) can be calculated at $500. The sale of the 100 shares of stock at a strike price of $50 to Trader B = $5,000 (P). The purchase of 100 shares of stock at $40 = $4,000 (Q). The put option premium paid to trader B for buying the contract of 100 shares at $5 per share, excluding commissions = $500 (R). Thus S = ( P - Q ) - R = ($5,000 - $4,000 ) - $500 = $500.

A put option is said to have intrinsic value when the underlying instrument has a spot price (S) below the option's strike price (K). Upon exercise, a put option is valued at K-S if it is "in-the-money", otherwise its value is zero. Prior to exercise, an option has time value apart from its intrinsic value. The following factors reduce the time value of a put option: shortening of the time to expire, decrease in the volatility of the underlying, and increase of interest rates. Option pricing is a central problem of financial mathematics.

Put option profit/loss chart

Purchased put option profit / loss chart. Long Put.PNG
Purchased put option profit / loss chart.

Trading options involves a constant monitoring of the option value, which is affected by changes in the base asset price, volatility and time decay. Moreover, the dependence of the put option value to those factors is not linear – which makes the analysis even more complex. One very useful way to analyze and track the value of an option position is by drawing a Profit / Loss chart that shows how the option value changes with changes in the base asset price and other factors. For example, this Profit / Loss chart shows the profit / loss of a put option position (with $100 strike and maturity of 30 days) purchased at a price of $3.34 (blue graph – the day of the purchase of the option; orange graph – at expiry).

The graphs clearly shows the non-linear dependence of the option value to the base asset price.

As time passes, the blue graphs move "downward", until it reaches the orange graph (which is the profit / loss at expiry) – this loss of value by the option is called "time decay".

See also

Options

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Covered call

A covered call is a financial market transaction in which the seller of call options owns the corresponding amount of the underlying instrument, such as shares of a stock or other securities. If a trader buys the underlying instrument at the same time the trader sells the call, the strategy is often called a "buy-write" strategy. In equilibrium, the strategy has the same payoffs as writing a put option.

In finance, a collar is an option strategy that limits the range of possible positive or negative returns on an underlying to a specific range. A collar strategy is used as one of the ways to hedge against possible losses and it represents long put options financed with short call options.

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The iron condor is an option trading strategy utilizing two vertical spreads – a put spread and a call spread with the same expiration and four different strikes. A long iron condor is essentially selling both sides of the underlying instrument by simultaneously shorting the same number of calls and puts, then covering each position with the purchase of further out of the money call(s) and put(s) respectively. The converse produces a short iron condor.

In options trading, a bull spread is a bullish, vertical spread options strategy that is designed to profit from a moderate rise in the price of the underlying security.

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Naked put

A naked put is a put option contract where the option writer does not hold the underlying position, in this case a short equity position, to cover the contract in case of assignment. The seller receives the premium cost of the put price, and hopes that the underlying equity or stock price stays the same or rises modestly, in which case the seller retains the premium. A put option buyer is hoping for a decrease in the price of the underlying equity, and upon exercise or expiration will collect cash representing the difference between the strike price of the option and the price of the underlying equity.

Iron butterfly (options strategy) name of an advanced, neutral-outlook, options trading strategy

In finance an iron butterfly, also known as the ironfly, is the name of an advanced, neutral-outlook, options trading strategy that involves buying and holding four different options at three different strike prices. It is a limited-risk, limited-profit trading strategy that is structured for a larger probability of earning smaller limited profit when the underlying stock is perceived to have a low volatility.

Option strategies are the simultaneous, and often mixed, buying or selling of one or more options that differ in one or more of the options' variables. Call options, simply known as calls, give the buyer a right to buy a particular stock at that option's strike price. Conversely, put options, simply known as puts, give the buyer the right to sell a particular stock at the option's strike price. This is often done to gain exposure to a specific type of opportunity or risk while eliminating other risks as part of a trading strategy. A very straightforward strategy might simply be the buying or selling of a single option, however option strategies often refer to a combination of simultaneous buying and or selling of options.

The backspread is the converse strategy to the ratio spread and is also known as reverse ratio spread. Using calls, a bullish strategy known as the call backspread can be constructed and with puts, a strategy known as the put backspread can be constructed.

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A naked call occurs when a speculator writes (sells) a call option on a security without ownership of that security. It is one of the riskiest options strategies because it carries unlimited risk as opposed to a naked put, where the maximum loss occurs if the stock falls to zero. A naked call is the opposite of a covered call.

Option (finance) right to to buy or sell a certain thing at a later date at an agreed price

In finance, an option is a contract which gives the buyer the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price prior to or on a specified date, depending on the form of the option. The strike price may be set by reference to the spot price of the underlying security or commodity on the day an option is taken out, or it may be fixed at a discount or at a premium. The seller has the corresponding obligation to fulfill the transaction – to sell or buy – if the buyer (owner) "exercises" the option. An option that conveys to the owner the right to buy at a specific price is referred to as a call; an option that conveys the right of the owner to sell at a specific price is referred to as a put. Both are commonly traded, but the call option is more frequently discussed.

Credit spread (options)

In finance, a credit spread, or net credit spread is an options strategy that involves a purchase of one option and a sale of another option in the same class and expiration but different strike prices. It is designed to make a profit when the spreads between the two options narrows.

In finance, a strangle is an investment strategy involving the purchase or sale of particular option derivatives that allows the holder to profit based on how much the price of the underlying security moves, with relatively minimal exposure to the direction of price movement. A purchase of particular options is known as a long strangle, while a sale of the same options is known as a short strangle. As an options position strangle is a variation of a more generic straddle position. Strangle's key difference from a straddle is in giving investor choice of balancing cost of opening a strangle versus a probability of profit. For example, given the same underlying security, strangle positions can be constructed with low cost and low probability of profit. Low cost is relative and comparable to a cost of straddle on the same underlying. Strangles can be used with equity options, index options or options on futures.

References

  1. "Archived copy". Archived from the original on 2015-11-18. Retrieved 2015-11-17.CS1 maint: Archived copy as title (link) Retail Investor Sentiment and the Stock Market | Matthias Burghardt*, Marcel Czink, and Ryan Riordan | page 15 | 4.2.3 Positive and negative sentiment