A put option is an option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time. This is quite opposite of a call option, which gives the holder the right to buy shares. If the price of the stock declines below the specified price of the put option, the owner/buyer of the put has the right, but not the obligation, to sell the asset at the specified price, while the seller of the put has the obligation to purchase the asset at the strike price if the owner uses the right to do so. In this way the buyer of the put will receive at least the strike price specified, even if the asset is currently worthless.Put buying is the simplest way to trade put options but should be careful.
When to purchase the put option?
When the options trader is bearish on particular security, he can purchase put options to profit from a slide in asset price.
Key point to get profit
When trading in put option you should be careful because it is opposite to call option and the put option is very valuable when the stock is getting depreciates relative to the strike price. The key point to remember here is the price of the underlying stock should move below the strike price(Significantly below the strike price) before the expiry date .
Example on put option
Suppose the stock of ABC Company is trading at $40. A put option contract with a strike price of $40 expiring in a month’s time is being priced at $2. You strongly believe that ABC’s stock will drop sharply in the coming weeks after their earnings report. So you paid $200 to purchase a single $40 ABC put option covering 100 shares. Assuming your predictions are correct, the price of ABC stock plunges to $30 after the company reported weak earnings and lowered its earnings guidance for the next quarter. With this crash in the underlying stock price, your put buying strategy will result in a profit of $800.
The most widely-traded put options are on stocks/equities, but they are traded on many other instruments such as interest rates (see interest rate floor) or commodities.
The put buyer either believes that the underlying asset’s price will fall by the exercise date or hopes to protect a long position in it. The advantage of buying a put over short selling the asset is that the option owner’s risk of loss is limited to the premium paid for it, whereas the asset short seller’s risk of loss is unlimited (its price can rise greatly, in fact, in theory it can rise infinitely, and such a rise is the short seller’s loss). The put buyer’s prospective risk of gain is limited to the option’s strike price less the underlying’s spot price and the premium/fee paid for it.The put writer believes that the underlying security’s price will rise, not fall. The writer sells the put to collect the premium. The put writer’s total potential loss is limited to the put’s strike price less the spot and premium already received. Puts can be used also to limit the writer’s portfolio risk and may be part of an option spread.
The put buyer/owner is short on the underlying asset of the put, but long on the put option itself. That is, the buyer wants the value of the put option to increase by a decline in the price of the underlying asset below the strike price. The writer of a put is long on the underlying asset and short on the put option itself. That is, the seller wants the option to become worthless by an increase in the price of the underlying asset above the strike price. Generally, a put option that is purchased is referred to as a long put and a put option that is sold is referred to as a short put.