What Put options are.
After having introduced the general concept of financial options and having seen deeper how Call options work in a trading framework, now we can take a look at the so called Put options. As usual, we will start with the classical definition and then we will go through a couple of examples to make things clearer with easy words. So…
A Put option is a contract which gives the owner the right but not the obligation to sell a financial instrument at or within a certain future expiry date at a fixed price.
Now we’ve made teachers happy, let’s see a more intuitive example in order to clear any doubt.
Put options: an example.
We are still at the pub and as we have already used our football team to bet on the championship result, by stipulating a Call option, we start speaking about the second topic in order of importance when conversating in these kind of places: the weather forecast.
Today there were 30 degrees, a nice weather, but in your opinion a perturbation will very soon determine a strong decrease in the temperature. In particular, you believe the thermometer will surely go below 25 degrees. Obviously I have to go against you, otherwise we’d get bored and conversation would loose intensity, that’s exactly why I’m convinced that 25 degrees is the minimum but most probably the temperature will be higher. At a glance our expectations are:
You: Temperature < 25°
Me: Temperature >= 25°
At this point, in order to inject some adrenalin to the matter, we make an agreement. You pay me straight away a small beer, that is to say you give me now 3 $, and if in one week’s time the temperature will remain above or equal to 25° I have won the bet. In this case I will thank you a lot for the generous gift, inviting you to bet more often.
Vice versa, if you are lucky and a storm makes the thermometer mark a lower temperature, I have to pay you a fixed amount, like in our previous cases let’s say 1 $, for every degree less. That’s why you will spend a week hoping for cold winds from the North Pole. Anyway getting back to our bet your earning’s structure follows this pattern:
On the other hand, since at the moment of the agreement you pay me 3 $, your profit/loss structure has the following dynamics (mine is obviously the other way round):
Well, this is a Put option on the weather conditions. All the related financial terms are the same we have already seen for the call options. Also in this case we have an underlying (the temperature), a premium (the initial 3 dollars), your possibility to exercise the option (in other worlds you can ask me to pay one dollar each degree less if you are right) and the expiration date (that is exactly one week if we stipulate a European option, or at any time from now to one week in the American option’s case).
Put options on the financial markets.
On financial markets it works exactly the same way, the only difference from our example is that the underlying is not the weather but a quoted economical variable. Let’s consider the case of the forex market where all the traders can buy and sell currencies.
Currencies are traded as cross (in simple words you can buy a currency using another one), so imagine an option written on the euro – dollar spot exchange rate. Watching the chart on your trading platform connected with the Chicago Mercantile Exchange you could see something similar to the following graph:
Now, within let’s say 3 months, you could be confident that the euro – dollar spot rate will be below 1,25 while on the other side I could be totally sure that in the worst case it will be equal to that but most probably the exchange rate will be far above it.
Well, here we have again all the ingredients for our Put option, this time on the euro – dollar exchange rate. Like in the previous example, you pay me a premium now and if you are right I will pay you the difference between the strike price and the market value at the expiration date (European option) or within the expiration date (American option). Vice versa if my forecast is correct I’ll keep all your premium for myself.
Buying a Put option.
Generally we can say that, when buying a Put option, the profit is represented by the exercise price value minus the market price, while the loss is determined by the initial premium that you pay.
This is the buyer pay off scheme (like in the call options graph you can see profits and losses on the vertical line and the underlying value on the horizontal one):
Selling a Put option.
In case of sale of a Put option, the pay – off has obviously an opposite trend. The profit is represented by the premium, while the loss is given by the strike price minus the market price at or within the expiration date. Graphically:
Put options: in/at/out of the money.
As you know some people like categorizations a lot, as it gives them the sensation of a clear and organized world. Options make no exception (sorry for the play on words, but it was too tempting 
). I’m telling you in advance, these names are uneuseful for trading pourposes because you will just watch the quotes on your trading platform and decide what to buy or sell. But sometimes they are used by traders, so it is better you know the basics. Having said this, we will have:
- Put option out of the money. When the market price is below the strike price, like in the example we have just considered.
- Put option at the money. When the exercise is “near” the market price, in our example 1,30. (How much “near” is a question of individual evaluation).
- Put options in the money. When the Put strike is above the market price. In our example this could be 1,35.
Some further specifications.
As already done for the Call options, a couple of final highlights. They are obvious, but it is always better to specify. The first is really simple: if you buy or sell ten contracts instead of just one, obviously you have to multiply profits, losses and premium by ten…and it’s all I’ll say on this, respecting your intelligence.
The second is a bit less evident but easy. According to the market you choose to trade in, the underlaying of an option can vary in quantity too. Referring to our forex example it could be equivalent to ten thousand as well as one hundred thousand euro – dollars. For stocks or bonds it is the same: the underlaying can be a pack of 100, 1000 or 10.000 shares. This quantity, as said for call options, is called notional.
Closing the circle: available strike prices, notional and expiration date if you trade on a regulated markets (which is most of the time) are established by the authority that supervises the market itself. In this way demand and supply can meet more easily.
Well, like Jim Morrison would say “this is the end my friend”: at this point you know everything you need in order to trade Put options. On the contrary, concerning the whole option issue, since we want to have a basic but hopefully complete picture, a couple of things are still missing, that is to say: how to determine an option’s price and the so called put – call parity.
