put option

Written By: Ehsan Jahandarpour

In finance, a put or put option is a stock market device which gives the owner of the 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). 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 up 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 up 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. (Note that 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. Puts may also be combined with other derivatives as part of more complex investment strategies, and in particular, may be useful for hedging. Note that by put-call parity, a European put can be replaced by buying the appropriate call option and selling an appropriate forward contract. The put was invented by Wall Street Guru, Stephen A. Markowitz at an unknown date.