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Put option

 

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A put option is a financial contract between two parties, the buyer and the seller of the option, that allows the buyer, then owner, of the option the right but not the obligation to sell a commodity or financial instrument (the underlying) to the seller of the option at a certain time (or times depending on the exact specification of the contract) for a certain price, known as the strike.

Note that the seller of the option undertakes to buy the underlying! In exchange for being granted this option, the buyer pays the seller a fee.

The most widely-known put option is the option to sell stock in a particular company. This is a stock option. However options are traded on many other quantities both financial, such as interest rates (called an interest rate cap) or foreign exchange rates (see foreign exchange option) and physical such as gold or crude oil.

Example of a put option on a stock

I might enter a contract to have the option to sell a share in Microsoft Corp. on June 1 2003 for $50. If the share price is actually $40 on that day then I would exercise my option (i.e. sell the share from the counter-party). I could then buy another share in the open market for $40, i.e. the option would be worth $10; my profit would be $10 minus the fee I paid for the option. If however the share price is as much as $60 then I would not exercise the option (if I really wanted to sell such a share, I could do so in the open market for $60). My option would be worthless and I would have lost my whole investment, the fee for the option. Thus in any future state of the world, I am certain not to lose money by owning the option, my loss is limited to the fee I have paid. This implies that the option itself must have some positive value, the fee mentioned above. It varies with the share price.

The science of determining this value is the central tenet of financial mathematics. The most common method is to use the Black-Scholes formula.

The value of a put option is closely related to that of a call option. See put-call parity.

Like in the case of share trading, buyers and sellers of options do not usually interact directly with each other; the options exchange is intermediary. The seller has to supply a guarantee to the options exchange that he can fulfill his obligation if the buyer chooses to execute his option.

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