Definition:
A put option is an option contract in which the holder (buyer) has the right (but not the obligation) to sell a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration).
For the writer (seller) of a put option, it represents an obligation to buy the underlying security at the strike price if the option is exercised. The put option writer is paid a premium for taking on the risk associated with the obligation.
A put option is an option contract in which the holder (buyer) has the right (but not the obligation) to sell a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration).
For the writer (seller) of a put option, it represents an obligation to buy the underlying security at the strike price if the option is exercised. The put option writer is paid a premium for taking on the risk associated with the obligation.
Buying Put Options
A Simplified Example
Suppose the stock of XYZ company is trading at Rs40. A put option contract with a strike price of Rs40 expiring in a month's time is being priced at Rs2. You strongly believe that XYZ stock will drop sharply in the coming weeks after their earnings report. So you paid Rs200 to purchase a single Rs40 XYZ put option covering 100 shares.If you were to exercise your put option after earnings, you invoke your right to sell 100 shares of XYZ stock at Rs40 each. Although you don't own any share of XYZ company at this time, you can easily go to the open market to buy 100 shares at only Rs30 a share and sell them immediately for Rs40 per share. This gives you a profit of Rs10 per share. Since each put option contract covers 100 shares, the total amount you will receive from the exercise is Rs1000. As you had paid Rs200 to purchase this put option, your net profit for the entire trade is Rs800.
This strategy of trading put option is known as the long put strategy.
Protective Puts
Investors also buy put options when they wish to protect an existing long stock position. Put options employed in this manner are also known as protective puts. Entire portfolio of stocks can also be protected using index puts.
Selling Put Options
Covered Puts
The written put option is covered if the put option writer is also short the obligated quantity of the underlying security. The covered put writing strategy is employed when the investor is bearish on the underlying.
Naked Puts
The short put is naked if the put option writer did not short the obligated quantity of the underlying security when the put option is sold. The naked put writing strategy is used when the investor is bullish on the underlying.For the patient investor who is bullish on a particular company for the long haul, writing naked puts can also be a great strategy to acquire stocks at a discount.
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Thanks for giving your valuable inputs, TRENDGURUS