Definition & Meaning:

A contract to reduce potential losses

This is a type of 'derivative'. A 'put option' (which is also called a 'sell option') is like a type of insurance when buying a financial security which is used to reduce a potential loss if the price of it falls in the future. It is a legal contract with a third party where you agree to have the option to sell (it is your decision if you do or not) to them a specific quantity of a financial asset (e.g. stock in a particular company, a specific bond etc...) at a pre-set price on or before a specific date in the future.

As it is a contract, the entity which creates the put option (called the 'writer') is legally obliged to buy from you the financial asset at the agreed price (called the 'strike price') if you decide to proceed with the sale ('take up the option') within the terms of the contract. To make it worth their while, the writer/creator of the put option will charge a fee (called a 'premium') to the investor who originally buys the put option contract from them and this is non-refundable.

The amount of this fee/premium varies on a number of different factors (e.g. the price the financial security will be bought at, the probability the financial security will reach that price in the market, length of time until the contract expires etc...). On put options for stock, you have to pay a fee/premium for each share you buy (e.g. $0.45 per share). In addition, there will be a set minimum quantity of the financial security that you would have to sell if you chose to do it. With stocks, it is normally 100 shares. Put options can be directly bought or traded through brokers.

Instead of choosing not to go through with the contract or settling it with the original writer of the contract, you can also resell the put option contract to another person through your broker before it reaches its 'expiration date'. If you do, you will also receive a fee from the person who has bought the contract from you. This fee will probably differ from the fee you originally paid as a result of a change in the perceived profitability of owning the contract.

Can be used for speculation

Although put options are often used by investors who already own the financial asset when they buy the contract (to reduce potential losses if things go badly with it), some investors/traders who use them don't. These investors/traders are not using put options to reduce losses (if the price of the financial asset falls), but to make money. In such a case, the investor/trader is taking a short position, speculating that the price of the financial security will fall on the market.

If an investor/trader is using a put option to make money, not only does the spot/current price of the financial asset need to be lower than the strike price (the agreed selling price) when the contract expires, but the difference between the two has to cover both the fee/premium paid per unit for the put option and also the commission per unit (charged by the broker) to buy a unit of the financial asset (e.g. 1% of its value). If the difference between the prices doesn't cover these, the option would make the investor a loss.

For example, if you buy a put option contract for a company's stock at a strike price of $25 and pay a fee of $0.50 for each share and pay a commission of $0.23 for buying each share, in order to make money you would need the actual share price to be below $24.27 when the option expires.

With some put option contracts, no actual trading of the financial asset it refers to occurs when the option expires/ends, but the two parties settle the difference between the spot/current and strike prices in cash. These are called 'cash-settled' options.

The opposite of a put option is called a 'call option'. This is a derivative contract with a third party where you have the option to buy stock for a specific price in the future.

Pronunciation:

Click to hear Put Option

Also Called:

Puts, Sell Options, Downside Contracts.

Related Vocabulary:

Call Option, Deriviatives.

Exercises:

To learn more vocabulary connected to financial trading, you can do our free online exercise on types of financial derivatives.