A put option usually called a “put” is in essence a financially binding contract between the buyer and the put writer of the option. The put allows the option buyer the right but not the obligation to sell a commodity or financial instrument. The option buyer purchases the contract based on ‘what ifs’. The buyer speculates and the seller or writer is obligated to payout if he speculates correctly. At times the concept can be very confusing. The process starts with the writer of the put option. In essence his contract states, the value of the stock in ABC Company limited is $50.00 per share as at today’s date; the writer states that they will buy 100 shares if the price of the share falls to $40.00 per share within the next six months. You might ask what good is this to you. However you pay a premium per share to purchase this option contract. Assuming the seller states $5.00 per share as a premium you would have to put upfront $500.00. Now if within the six months the price falls $40.00 then you can purchase 100 shares of ABC stock at $40.00 each and the writer would then buy them from you at $50.00 each. This is a very good profit. However if the price does not reach $40.00 after that time then you would have lost the premium. This is a very common type of stock option put.
To assist with this we have added the definition to some terms that are commonly used when dealing with stock option puts:
- Writer – The seller of the option contract
- Buyer – The person that enters into the contract with the writer or buyer.
- Spot Price – The price of the stock or commodity at market.
- Strike Price – The price as stipulated by the contract.
- The Premium – The amount the buyer pays to enter into the contract.
The real trick in stock option puts is that the writer or the seller agrees to buy the stock IF the buyer exercises the option. The consideration in the contract is the fee or the premium that the buyer pays up to have the option to do so. There are some differences in stock option, the most notable being in the European types versus the American type stock option. The European stock option put permits the buyer to only exercise the stock option put for only a short period of time that is up to the point of the expiration of the option. The American stock option put allows the buyer to exercise the option at any time during the life of the option contract.
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