What it means
A put is one of the two basic types of option, the other being a call. The buyer pays an upfront fee, called the premium, in return for the right to sell at the strike price (the fixed price named in the contract).
If the market price falls below the strike price, the right becomes valuable, and if it does not, the put simply expires and the buyer loses only the premium. The most common use is protection.
An investor who owns shares and fears a drop can buy a put as a form of insurance, which sets a floor under the value of the holding. The premium is the cost of that insurance, and the maximum loss is capped.
Puts can also be used to speculate on a fall in price. A trader who expects a share to decline can buy a put without having to borrow and sell the shares short.
The risk is limited to the premium paid, which is a key difference from short selling where losses can be large. The seller of a put, sometimes called the writer, collects the premium but accepts the obligation to buy at the strike price if the holder exercises.
Sellers do this to earn income or to buy shares at a price they find attractive. Their potential loss is large if the asset price collapses, so sellers must post collateral.
The value of a put is affected by several things. The price of the underlying asset, the strike price, the time left until expiry, the expected size of price swings (volatility) and interest rates all matter.
A put with more time left, or one on a more volatile asset, generally costs more. A nuance is that a put is often priced in relation to a call at the same strike price through a relationship known as put-call parity.
Another point is that many exchange-traded options are on blocks of 100 shares, so the cost of one contract is the quoted premium multiplied by 100.
In practice
Real-world examples.
Example
A fund manager holds $2,000,000 of shares and worries about a market fall before the year end. She buys put options on a market index that rise in value if prices drop. If the market falls 10%, the gain on the puts offsets much of the loss on the shares.
Example
An airline fears that falling demand will hit its own share price, which it plans to use for acquisitions. It cannot easily hedge its own shares, so its treasurer instead buys puts on a basket of competitor shares as a partial hedge. The position gains if the whole sector falls.
Example
A private investor wants to buy a company's shares but believes they are slightly overpriced. She sells a put at a strike price just below the current price and collects a premium of $2 per share. If the share price drops, she buys the shares at the strike price, effectively at a discount.
Formula
Calculation
Profit at expiry for a put buyer = (strike price - market price at expiry, if positive) - premium paid
Break-even price = strike price - premium
Suppose an investor buys one put contract on 100 shares with a strike price of $50 and pays a premium of $3 per share. The cost is 3 x 100 = $300. If the share price falls to $42, the put is worth 50 - 42 = $8 per share, so the profit is (8 - 3) x 100 = $500. The break-even price is 50 - 3 = $47, and if the share price stays above $50 the put expires worthless and the loss is the $300 premium.Case study
Seen in the real world.
Kestrel Farms is an illustrative, fictional grain producer that expects to harvest 500,000 bushels in six months. The finance manager is worried that the market price will drop before harvest and wipe out the margin. Rather than sell the crop in advance, which would give up any benefit from a price rise, she wants a floor.
She buys put options on grain at a strike price of $6.00 per bushel for a premium of $0.30 per bushel. At harvest, the market price has fallen to $5.20. The puts let Kestrel sell at $6.00, so the net price is 6.00 - 0.30 = $5.70 per bushel, compared with $5.20 without the hedge.
The illustrative lesson is that a put works like insurance. Had prices risen instead, Kestrel would have let the puts expire and sold at the higher market price, having lost only the $0.30 premium.
Watch out
Common mistakes.
- Believing a put buyer is obliged to sell, when the buyer holds a right and can simply let the contract expire.
- Forgetting that the premium must be recovered before the put shows a profit, so the break-even is the strike price minus the premium.
- Selling puts as an easy income source without considering that the potential loss is large if the price falls sharply.
Questions
People also ask.
What is the difference between a put and a call?
A put gives the right to sell at a fixed price, while a call gives the right to buy at a fixed price.
Can a put lose more than the premium?
For the buyer, no; the maximum loss is the premium paid, whereas the seller can lose far more than the premium received.
What does it mean for a put to be in the money?
It means the market price is below the strike price, so using the right would give a positive payoff.
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