Put option definition

What is a put option?

A put option is a contract that gives the buyer the right but not the obligation to sell an asset at a specific price, at a specific date of expiry. The value of a put option increases if the asset's market price depreciates.

The seller, also known as the writer, has the obligation to buy the underlying asset – at the agreed upon price, known as the strike price – if the option is executed by the buyer, also known as the holder. The writer is paid a premium for accepting the associated risks of taking on the obligation to buy.

Example of a put option

Let’s say that you thought that the share price of company ABC was going to fall from its current price of £30, and so you decide to open a put option with a strike price of £25. For stock options, each contract is worth the equivalent of 100 shares, but the price is usually quoted for one share.

When dealing options, there is always a premium to be paid. If the premium of this option was £1 per share, your total premium is £100.

If the price of ABC stock did fall, to a market price of £20, you could execute your right to sell the stock for the agreed strike price of £25 a share.

To calculate the profit, you subtract the market price from the strike price, giving you a profit of £5 per share. Since put options come in lots of 100 shares, you multiply that £5 per share profit by 100, which yields a gross profit of £500. After deducting the £100 premium, you would be left with a net profit of £400.

However, if the market had moved against you, you could let the option expire and your maximum loss would be cost of the initial £100 premium.

Pros and cons of put options

Pros of put options

Put options allow you to bet against the market because instead of taking ownership of an asset, you are speculating on an asset’s price movement. Since they can be used to short the market, you can use put options as a hedge against your other active positions in case one of them falls in value.

When you are buying a put option, your losses would be capped at the total cost of your deposit. However, if you are selling a put, the market could move all the way to zero.

Cons of put options

Options are susceptible to time decay, which means that the value of an out-of-the-money options contract decreases as it gets nearer to its expiry date.

Put options are complicated and could be costly for beginner traders who aren’t aware of the risks. This makes it important for traders to have a risk management strategy in place before they start trading.