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.
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.
