Legal Definitions - put option

A put option is a financial contract that grants its owner the right, but not the obligation, to sell a specific underlying asset at a pre-determined price (known as the "strike price") on or before a particular date (the "expiration date"). The underlying asset can be various financial instruments, such as stocks, bonds, commodities, currencies, or index funds.

Investors typically purchase a put option when they anticipate that the market price of the underlying asset will decrease. If the asset's price falls below the strike price before the expiration date, the owner can "exercise" the option, selling the asset at the higher strike price, thereby profiting from the decline or protecting an existing investment from further loss. The party who sells the put option has the obligation to buy the underlying asset if the owner chooses to exercise their right.

• Protecting an Investment (Hedging)

  Scenario: Sarah owns 500 shares of "GreenEnergy Inc." stock, which she bought at $75 per share. The stock is currently trading at $80, but she's concerned about a potential downturn in the renewable energy sector due to upcoming policy changes. She doesn't want to sell her shares yet, but she wants to limit her potential losses. Sarah buys a put option with a strike price of $70, expiring in six months, for a small premium.

  Explanation: If GreenEnergy Inc.'s stock price drops to $60 per share within the six-month period, Sarah can exercise her put option. This allows her to sell her 500 shares at the agreed-upon strike price of $70, even though the market price is only $60. This action protects her from a more significant loss, as she effectively locks in a minimum selling price for her shares, minus the cost of the option.

• Speculating on a Price Decline

  Scenario: David believes that the price of crude oil, currently trading at $85 per barrel, is likely to fall significantly in the next three months due to an expected increase in global supply. He doesn't own any crude oil, but he wants to profit if his prediction is correct. David purchases a put option on crude oil futures with a strike price of $80 per barrel, expiring in three months.

  Explanation: If crude oil prices indeed drop to $70 per barrel before the option expires, David can exercise his put option. This gives him the right to "sell" crude oil at $80 per barrel. He can then immediately buy crude oil at the market price of $70 per barrel to fulfill his obligation, making a profit of $10 per barrel (minus the cost of the option). This demonstrates how a put option can be used to profit from an anticipated price decrease without actually owning the underlying asset beforehand.

• Currency Risk Management for Businesses

  Scenario: A U.S.-based electronics manufacturer, "GlobalTech," is expecting a payment of 2 million British Pounds (£) in four months from a major client in the UK. The current exchange rate is $1.25 per £. GlobalTech is concerned that the British Pound might weaken against the U.S. Dollar before they receive the payment, which would reduce the dollar value of their revenue. To mitigate this risk, GlobalTech buys a put option on British Pounds with a strike price of $1.22, expiring in four months.

  Explanation: If, in four months, the exchange rate drops to $1.18 per £, GlobalTech can exercise their put option. This allows them to sell their 2 million British Pounds at the guaranteed rate of $1.22 per £, rather than the lower market rate of $1.18. This ensures they receive a predictable dollar amount for their payment, protecting them from adverse currency fluctuations.