UK Accounting Glossary
In options trading, a put option is a bet that the value of its underlying security will fall. A buyer pays a premium to a writer (i.e. seller) for the right, but not the obligation, to sell the underlying security to the writer at any time on or before the expiration date, at price predetermined a strike (for an American-style option). If the value of the underlying security falls below the strike price, the put option is said to be in-the-money.
For example, an investor who wants to purchase a put option on XYZ, Inc. when its stock is trading at $42 in August might buy a September 40 put option for 100 shares. Assume the trader purchases the put option for $2 — the premium of the put option would be $2 X 100 shares or $200. If XYZ’s stock price falls to $35, the put option would be in-the-money for $5 ($40 minus $35) and the trader could sell his 100 shares of XYZ for $40, netting $500 from that transaction. However, the overall profit of the transaction would be $300 ($500 minus the $200 premium). On the downside, XYZ would need to drop to at least $38 for the put option to break-even. The above example does not take into account the commissions required to execute the put option.
A put option is out-of-the-money if the value of the underlying security is higher than the strike price. If the buyer does not exercise the put option, the put option is said to expire worthless. In the XYZ, Inc. put option example above, if the stock does not trade below the strike price of $40, the investor would not exercise the put option. As a result, the put option would expire worthless and the buyer of that put option would lose the entire premium of $200.
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This glossary post was last updated: 6th February 2020.