What is a Put Option?

A put option is a type of financial instrument known as a derivative. It is basically an agreement between two parties to exchange ownership of a stock at an agreed upon price within a certain time period. The exchange of the stock is optional and the owner of the option decides whether it takes place.

The agreed upon price of the exchange is called the strike price, and the date on which the option expires is the expiry date. The amount of money required to purchase one is called the premium. If the exchange takes place, then one is said to have exercised the option.

Put option premiums are always quoted per stock, but they are sold in lots of 100 shares minimum. These options are always an agreement about being able to sell the stock at the agreed upon price. They come in both European style and American style, and are sold on European and North Amercian exchanges, respectively. European options can only be exercised on the expiry date, while American style options can be exercised at any time during the life of the option.

There are two investment styles when investing in this type of instrument. Conservative investors purchase one on stock that is part of their portfolio as an insurance policy against a large drop in the price of the stock. For example, if a conservative investor owns stock in company XYZ and is concerned that the stock price may decline but is unwilling to sell the stock, he can buy a put option to ensure that, if XYZ stock were to dramatically decline in price, the investor would be able to sell the stock at the strike price of the option. If XYZ stock is selling at $45 US dollars (USD), it could be purchased with a strike price of $43 USD.

At any time during the life of the option, the owner may sell the stock for $43 USD per share. This would only be done if the price of the share were to fall below that amount. The price of this option will depend on a number of variables but will be much less then $43 USD, typically in the $1 to $2 USD range. This example is only relevant to the American style.

The speculative investor either purchases or sells options without owning the underlying stock. Selling one is also called "writing" it, and the seller is said to be its writer. If a speculative investor thinks XZY stock is going to increase in value, then the investor will be a writer since, when the stock price of XYZ company increases in value, the options decrease in value. If a speculative investor thinks XZY stock is going to decrease in value, then the investor will be a buyer, since when the stock price of the company decreases in value, the put options increase in value.

The use of these instruments allows the speculative investor to dramatically increase the profit he earns compared to making purchases in the stock or company itself due to the leverage that is built into the option. For example, if the investor thinks XYZ stock currently selling for $45 USD per share is likely to decline to $43 USD per share, a put option with a $45 USD strike could be purchased for close to $1 USD. If the price does in fact decline to $43 USD, the option value will increase in value to $2 USD or possibly even more. If the stock price does not decline as expected, however, then the investor will lose the entire amount invested.