How a Put Option Works

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A put option is a contract designed for a subscriber of an option to sell a security or other asset (the underlying) at a predetermined price (exercise price) on a specific date known as the maturity date. It allows the buyer of the put to hedge against, or bet on a decline in the price of the underlying security.

Premature exercise of the option is mostly due to the disadvantage of the remaining time value. Upon exercising you obtain only the intrinsic value, plus time value. In practice, an exercise can still be useful if the option for either the market price is offered or the bid-ask spread is greater.

The first goal of these put options is to protect against declining prices of the underlying. For example, the purchaser of a share, buying a put hedges against a drop in the the exercise price. The put acts as an insurance, hence the name given to its premium price.

The option also allows the purchaser to speculate on the decline of the underlying, limiting the risk, since only the premium is engaged. In contrast, the speculator who wishes to sell a put option estimates that the price of the underlying does not fall below the exercise price by the due date.

Buying or selling an option, put or call, is a way to speculate on the volatility of the underlying asset: the buyer speculates on its appreciation and while the seller anticipates a decline.

The seller of the put option is obliged to purchase the underlying security. For this obligation, the seller receives the option premium from the buyer of the option. The buyer of a put option will exercise his right only if the price falls below the exercise price of the underlying asset.

In practice, the underlying security is not necessarily delivered upon exercise of the option. Instead, the buyer simply pays the difference between the exercise price and the price of the underlying at the time of settlement – a practice known as cash compensation. Whether a cash settlement takes place or the underlying is delivered, the terms around such events are all set in the contract.

Buyers of put options are also in a position to gain from the capacity to trade the underlying instrument at an inflated price (proportional to the current market value) and buy back their position at a lower current market price.

The valuation of a put before the maturity date is not easy since one must estimate the value of the underlying in the future. Nevertheless, the most common method used is the Black-Scholes model.

If the underlying is a share of a listed company issuing the dividend payment, the issuer generally anticipates lower mechanical share price equal to the dividend by integrating an additional parameter in their valuation model.

 

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