What’s a Put Option? A put option provides the holder of the stock the right, but not the duty to offer the underlying asset at particular price during a period
of time. The other party to the transaction has the duty to purchase, if you possess the right to sell an alternative. That’s the reason it’s referred to as a put because you’re “placing” the asset into the control of the stocks seller at the agreed upon exercise price. This causes the choice to grow in value as the cost of the asset falls.
Let us have a glance at our earlier case of Co and Widgets to see how a put option functions and why it gets value once the underlying asset price falls. It is January 2012.You understand the stock exchange has shown an exceptionally strong seasonal tendency to fall during January and April.
You desire to possess a stock that increases in value once the marketplace drops, because Widgets and Co shares have a tendency to rise and fall with the marketplace. You need to possess a put option. Co and widgets is trading at 100 in January.
Remember, the strike price is the cost at which the option may be exercised.
If you need to sell the seller of-the put option, who will be obliged to purchase from you the shares of Co and Widgets, demands compensation for giving the right to you to sell Widgets and Co to him at 100. The damages you give him (e.g. the cost of the inventory you pay) is called the option premium.
The cost of the alternative in January is 3. Now let us fast forward to April. Let us look at what it is going to be worth as Widgets and Co shares fluctuate. You’d possess the right to sell the stock to the man who offered you the choice.
The price at which you’d sell Widgets and Co put option will be the exercise price of 100. Remember, the man who sells the put option has the duty to purchase it from you at the cost. Therefore, as is the right under the alternative, you can purchase the stock in the open market at 80 and instantly sell it to the grantor at 100. By immediately selling it for 100 and purchasing Widgets and Co at 80, your net is 20. What about when Co and Widgets is at 90? Whenever you purchase at 90 and sell at 100, you get 10, that is the put option’s worth.
How about if Co and Widgets is trading at 100? In this instance, it actually does not matter.
You may purchase the shares in-the open market for 100, and exercise your right to promote them at 100. But this will just be a break even trade. At the least, one could say that there’s no extra value to exercising the put option, so it’s basically useless. Much like a call option, any option whose exercise price is similar to the present market price is believed to be “atthe cash”.
You may exercise your right to place the stock to the option seller. Your right will be to offer it at 100, in the event you purchased Widgets and Co at 110. And why would anyone buy anything at 110, just to sell it at 100? It automatically locks in a reduction of10. Because you possess the right and aren’t obliged to do that, you would do nothing – the alternative is unworthy.
Usually, what happens if Co and Widgets shares go to 120? But Co and Widgets shares are trading at 120. So you would need to pay 120, only to offer the shares at 100, hence locking in loss of -20. Since you possess the right and aren’t obliged to try it the put option is unworthy.
Let us look at another example, using a product. In this scenario, let us look at soybeans. November it’s. You believe soybeans will go down during winter months. You purchase a March 700 put option. March soybeans options really expire in February. The exercise price, or strike price, in this example is 7.00, however it is commonly abbreviated to 700 on most quote machines as well as in the financial papers. If soybeans were 5.00, would you exercise the set option to promote them at 7.00? Sure thing! You’d make 2.00 on the exercise so 2.00 is the put option’s intrinsic worth. You may purchase soybeans at 6.00, contact the put option seller and place soybeans into his hands for a cost of 7.00. You’d make 1.00 on the exercise. Maybe. But not likely. In the end why bother purchasing soybeans at 7.00, just to sell them to someone for 7.00? How about 8.00? Absolutely not! Remember, a place gives the right to you to sell. So that you can exercise your put option, you’d need to purchase soybeans in the open market at 8.00. In this instance, you’d be purchasing high (at 8.00) and selling low (at 7.00), locking in a reduction of -1.00. But remember, you possess the right to promote not the duty to promote, so you do nothing. Thus the put option is unworthy. It’s the same thing, if soybeans are at 9. 00! So that you can exercise your option, you’d need to purchase soybeans in the open market 9.00. In this instance, you’d be purchasing high (at 9.00) and selling low (at 7.00), locking in a reduction of -2.00. But remember, you possess the right to promote not the duty to promote, so you do nothing. So the put option is unworthy. As you may see through these examples, a put’s exercise worth increases while the cost of-the underlying asset decreases. It does so by providing the right to the put option holder to sell at a predetermined cost. If the cost of the asset falls, the option holder can purchase the asset in the present market price, place the asset into the option grantor’s hands (i.e., promote it to the option grantor), and collect the agreed upon deal value, that is the strike cost of the option.
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