A put option, frequently simply referred to as a "put", is a financial deal amongst two individuals, the buyer and the seller. The purchaser of the put has the right, but not the requirement to sell an agreed quantity of say, a stock, to the seller of the option at a particular time (called the expiration date) for a certain price (called the strike price). The seller is obliged to buy the stock if the purchaser so decides. The purchaser pays a fee (called a premium) for this right.
One use of a put is as a type of insurance. In the protective put strategy, the investor buys enough puts to cover his stock holding so that if a drastic downward movement of the stock's price occurs, he has the option to sell the holdings at the strike price. Another use is for speculation: an investor can take a short position in the underlying stock without trading in it directly.
The buyer of a put (Put Option Graph on the left) purchases it in the wish that the price of the root instrument will drop in the near future. The seller of the option frequently expects that it will not, or is ready to give up a little of the profit from a price fall in return for the premium and retaining the opportunity to make a profit if the stock moves up instead.
Put options are the most successful for the purchaser when the stock goes down, making the price of the stock closer to, or below, the strike price. The put buyer thinks it's likely the price of the stock will likely drop below the option's strike price by the expiration date. The buyer's maximum loss is limited to the option premium he paid. The revenue for the buyer could be quite significant, and is determined by exactly how low the stock falls. When the price of the stock is lower than the strike price, the option is said to be "in the money".
The put writer (seller) does not believe the price of the underlying security is likely to fall below the strike price. The writer sells the put to collect the premium and does not receive any gain if the stock falls below the strike price.
The original transaction (buying/selling a put option) is not the supplying of a physical or financial asset. Instead it is the granting of the right to sell the stock, in return for a cost — the option price or premium.
Put options can be bought on many financial instruments besides stock in a corporation. Options can be purchased on futures on interest rates and on commodities like gold or crude oil.
Example of a put option on a stock:
John purchases a put contract to sell 100 shares of XYZ Corp. to Martha (Put Writer/Seller) for $50 per share. The present XYZ price is $55 per share, and John pays Martha a premium of $5 per share. If the price of XYZ stock falls to $40 a share before expiration, then John can exercise the put by purchasing 100 shares for $4,000 from the stock market, then selling them to Martha for $5,000.
John's total earnings can be calculated at $500. The sale of the 100 shares of stock at a strike price of $50 to Martha = $5,000. The purchase of 100 shares of stock at $40 = $4,000. The put option premium paid to Martha for buying the contract of 100 shares at $5 per share, excluding commissions = $500. Thus John's profit is ($5,000 - $4,000 ) - $500 (premium) = $500.
If, then again, the share price never drops below the strike price (in this case, $50), then John would never exercise the option (simply because selling a stock to Martha at $50 would definitely cost John more than that to buy it). John's option would be valueless and he would have lost the entire financial investment, the fee (premium) for the option contract, $500 ($5 per share, 100 shares per contract). John's total loss is limited to the cost of the put premium as well as the sales commission to buy it. A better way to earn income if the stock does go below the strike price is to simply sell the option before expiration. This is what most traders will do!!!
I do NOT buy put options because it requires you to KNOW with certainty which way the market will move. From the above example you can see that the stock must move a LARGE amount for you to make any money!!! Thus the probability of consistent success buying puts is VERY low.
Most people get lured into options because of the huge POTENTIAL gain. But what they do NOT realize is the large gains seldom materialize. The average investor only wins 30% of the time. What they fail to do is to consider the probability of success of getting a high gain. They are told to make sure they have a reward to risk ratio of at least 2:1. BUT they are never told to consider the probability of success!!! What good does it do to have a high reward to risk ratio if the probability of success is only 10% or less.
The trading strategy below insures a monthly gain of 3 to 8% with a success rate of 99+%.
After spending hundreds of hours analyzing how the market moved weekly for 25 years, I’ve developed what I call the Remarkable Iron Condor Strategy.
It has the following characteristics:
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