What Are Put Options

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The best way to begin our introduction to options trading is to define exactly what options are. Although commonly referred to simply as options, the full term is options contracts, because they are financial contracts between two parties.

In very basic terms, they specify a future transaction on a specified asset at a specified price. The buyer of the contract has the right, but not the obligation, to initiate that specified transaction. The seller of the contract has the related obligation to carry out the transaction should the holder choose to initiate it. There are several characteristics put options contract definition options that essentially make up the terms for any given contract.

The easiest way to define an options contract is to identify those characteristics and explain what they are. We have done exactly that below, and we have also provided some example options to give a clear idea of what they are and how they work.

An options contract consists of two parties: The writer is effectively the seller of the contract, while the holder is effectively put options contract definition buyer. When the writer of the contract sells it to the buyer, they collect a payment from the buyer and that's commonly referred to as the premium. It's the holder of the contract that has the option to engage in the transaction that is specified and the writer that is obliged to engage in the transaction should the holder wish to go ahead.

If the holder chooses to initiate the transaction specified in the contract, they are said to be exercising their option. Should the holder not choose to exercise their option at any point, then the contract will eventually expire and cease to exist.

You can read more about exercising an option here. Options are a form of derivative; which basically means they derive their value from an underlying asset. In an options contract the underlying asset is the asset which is specified in the transaction the holder put options contract definition the right to carry out. For example, a contract might give the holder the right to purchase stock in Company Put options contract definition, in which case Company X stock is the underlying asset.

The term underlying security is also commonly used, but both terms refer to the same thing. There's a range of financial instruments that can be the underlying asset in an option. Stock is the most commonly used asset, but bonds, indices, foreign currencies, commodities, or futures can all be used too.

There are even basket options, in which the underlying asset is a collection of different assets. The strike price is the price at which the specified transaction is put options contract definition be put options contract definition out at should the holder choose to exercise their option. Strike price is the term most commonly used, but it can also be known as the exercise price. The expiration date of an option is, quite simply, the date on which the put options contract definition will expire.

Options are typically relatively short term and last just a few weeks, although they can also last for a few months or up to a year. If the expiration date passes and the holder hasn't chosen to exercise their option, then the contract expires worthless. There are actually put options contract definition different types of options, because they can be classified in a variety of different ways. In a very broad sense though, they can be categorized based on whether put options contract definition give the holder the right to buy put options contract definition sell the underlying asset.

In this sense, there are basically two main types; call options which give the holder the right to buy the underlying asset at the strike price, and put options which give the holder the right to sell the underlying asset at the strike price. It should be noted that you don't have to actually own any of the underlying asset to buy a put option, but if you choose to exercise your option to sell the underlying asset you will, in theory, have to buy the underlying asset at that put options contract definition.

Please see our section on the Types of Options for further details on this. Another way that options can be categorized is based on their exercise style. They can basically be one of two styles: American style or European style. These terms have nothing to do with anything geographical though. An American style option is one where the holder can exercise their option at any time during the term of the contract, up put options contract definition and including the date of expiration.

A European style option is one where the holder can only exercise their option, should they wish to, at the point of expiration. American style options clearly offer much more flexibility to the holder, and because of this they are generally more expensive to buy. When the holder exercises their option, the contract is effectively being settled, and there are two ways in which settlement can take place.

They are physical settlement and cash settlement. Physical settlement is where the underlying asset is actually transferred between the buyer and the holder at the agreed strike price.

Cash settlement is where the put options contract definition receives a cash payment based on any profit they could effectively make through exercising their option. Please see Options Settlement for more details. When the writer of an options contract sells it to a buyer, the buyer makes a payment in order to purchase it. However, the amount that the buyer pays isn't the same amount that the writer receives.

Options are typically bought and sold on the public exchanges, where the transactions are facilitated by market makers. They basically exist to ensure that there's always a market for options contracts.

If someone wishes to sell, and there is no buyer, then the market maker put options contract definition act as the buyer and complete put options contract definition necessary transaction.

If someone wishes to buy, but there is no seller, then the market maker will act as the seller. Market makers make a small profit on each transaction. Options contracts are listed on the exchanges with two prices: The bid price is the price you would receive for writing options contracts, and the ask price is the price you would pay for buying them.

It's important to note that options contracts aren't just sold to buyers at the time of being written; holders of existing options contracts can also sell them to other buyers. Again, put options contract definition seller would receive the bid price and the buyer would pay the ask price. You can read more about the price of options here.

To help you fully understand what an options contract is we have provided a couple of examples below, featuring some different characteristics. The holder could exercise their option at any time because it's an American style options contract.

Put options contract definition you didn't own the relevant stock, you would have to first buy it and then sell it on to the holder. If the holder chose not to exercise their option by the expiration date, then it would expire worthless and your obligation would cease.

Alternatively, you could hold on to the stock if you preferred. If you chose not to exercise your option by the expiration date, your contract would expire worthless. The holder could only exercise their option at that point as it is put options contract definition European style option. Cash settlement options are typically settled put options contract definition if the holder is effectively in profit.

As a cash settlement option, you could expect it to be put options contract definition exercised if you were in profit. Definition of an Options Contract The best way to begin our introduction to options trading is to define exactly what options are.

Section Contents Quick Links. Parties Involved An options contract consists of two parties: Underlying Asset Options are a form of derivative; which basically means they derive their value from an underlying asset. Strike Price The strike price is the price at which the specified transaction is to be carried out at should the holder choose to exercise their option. Expiration Date The expiration date of an option is, quite simply, the date on which the contract will expire.

Option Type There are actually many different types of options, because they can be classified in a variety of different ways. Option Style Another way that options can be categorized is based on their exercise style. Option Settlement When the holder exercises their option, the contract is effectively being settled, and there are two ways in which settlement can take place. Bid and Ask Price When the writer of an options contract sells it to a buyer, the buyer makes a payment in order to purchase it.

Examples of Options Contracts To help you fully understand what an options contract is we have provided a couple of examples below, featuring some different characteristics. Example 1 Underlying Asset: Stock in Company X Strike Price: Call Option Option Style: Physical Settlement Bid Price: Example 2 Underlying Asset: Stock in Company Y Strike Price: Put Option Option Style: Cash Settlement Bid Price: Read Review Visit Broker.

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In finance, a put or put option is a stock market device which gives the owner of a put 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. 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.

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: 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. 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.

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 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. 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 as a "gift" for playing the game. 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: 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.

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. 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. 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: Option pricing is a central problem of financial mathematics.

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

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