Put option definition

A put option is a contract used in options trading that gives the buyer the right but not the obligation to sell an underlying asset at a specific price and predetermined date. The predetermined price which the buyer sells the option is called the strike price. Put options increase in value if the underlying asset’s market price falls. Unlike the traditional trading of securities such as stocks, wherein a position can be open indefinitely, an option contract can expire.

Put options can be traded with a variety of underlying assets, including currencies, bonds, stocks, commodities, and indices. A put option is the opposite of a call option, which gives holders the right to buy the underlying asset at a specific date and price.

How put options work

As a put option becomes more valuable when the price of the underlying asset decreases, they are typically used for hedging purposes, or to speculate on the downturn of a particular asset. Conversely, the value of a put option decreases when the price of the underlying asset increases.

When traders buy a put option, they are speculating that the value of the underlying asset will decrease over the course of the contract.

When traders sell a put option, they are speculating that the value of the underlying asset will rise or stay the same over the course of the contract.

Advantages of put options

Below are a few reasons put options may be appealing to investors:

Limit risk: Put options can be used as a method of limiting risk when used as a hedge. For instance, a trader who has a long position open on a stock fears the market will dip in the short-term. However, they do not want to close out their position. They can then buy a put option, so that if the stock price does decline, they can exercise the option and offset the losses they may incur from their original position. If the stock price does not decline, they can simply let the option expire worthlessly.

Generate income from the premium: Investors can sell options to generate an income. This is ideal in rising markets, where selling a put option can help produce incremental returns.

Potential to profit from falling asset prices: When the markets are falling, an investor can purchase a put option to capitalise on the situation and potentially profit from it.

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