Stock option definition finance
In this way the buyer of the put will receive at least the strike price specified, even if the asset is currently worthless. If the strike is K , and at time t the value of the underlying is S t , then in an American option the buyer can exercise the put for a payout of K-S t any time until the option's maturity time T.
The put yields a positive return only if the security price falls below the strike when the option is exercised. A European option can only be exercised at time T rather than any time until T , and a Bermudan option can be exercised only on specific dates listed in the terms of the contract.
If the option is not exercised by maturity, it expires worthless. The buyer will not exercise the option at an allowable date if the price of the underlying is greater than K. The most obvious use of a put is as a type of insurance. In the protective put strategy, the investor buys enough puts to cover his holdings of the underlying so that if a drastic downward movement of the underlying's price occurs, he has the option to sell the holdings at the strike price.
Another use is for speculation: Puts may also be combined with other derivatives as part of more complex investment strategies, and in particular, may be useful for hedging.
By put-call parity , a European put can be replaced by buying the appropriate call option and selling an appropriate forward contract. The terms for exercising the option's right to sell it differ depending on option style. A European put option allows the holder to exercise the put option for a short period of time right before expiration, while an American put option allows exercise at any time before expiration. The put buyer either believes that the underlying asset's price will fall by the exercise date or hopes to protect a long position in it.
The advantage of buying a put over short selling the asset is that the option owner's risk of loss is limited to the premium paid for it, whereas the asset short seller's risk of loss is unlimited its price can rise greatly, in fact, in theory it can rise infinitely, and such a rise is the short seller's loss.
The put writer believes that the underlying security's price will rise, not fall. The writer sells the put to collect the premium. The put writer's total potential loss is limited to the put's strike price less the spot and premium already received. Puts can be used also to limit the writer's portfolio risk and may be part of an option spread.
That is, the buyer wants the value of the put option to increase by a decline in the price of the underlying asset below the strike price. The writer seller of a put is long on the underlying asset and short on the put option itself. That is, the seller wants the option to become worthless by an increase in the price of the underlying asset above the strike price. Generally, a put option that is purchased is referred to as a long put and a put option that is sold is referred to as a short put.
A naked put , also called an uncovered put , is a put option whose writer the seller does not have a position in the underlying stock or other instrument. This strategy is best used by investors who want to accumulate a position in the underlying stock, but only if the price is low enough.
If the buyer fails to exercise the options, then the writer keeps the option premium as a "gift" for playing the game. If the underlying stock's market price is below the option's strike price when expiration arrives, the option owner buyer can exercise the put option, forcing the writer to buy the underlying stock at the strike price.
That allows the exerciser buyer to profit from the difference between the stock's market price and the option's strike price. But if the stock's market price is above the option's strike price at the end of expiration day, the option expires worthless, and the owner's loss is limited to the premium fee paid for it the writer's profit. The seller's potential loss on a naked put can be substantial. If the stock falls all the way to zero bankruptcy , his loss is equal to the strike price at which he must buy the stock to cover the option minus the premium received.
The potential upside is the premium received when selling the option: The buyer pays a fee called a premium for this right. The term "call" comes from the fact that the owner has the right to "call the stock away" from the seller. Option values vary with the value of the underlying instrument over time.
The price of the call contract must reflect the "likelihood" or chance of the call finishing in-the-money. The call contract price generally will be higher when the contract has more time to expire except in cases when a significant dividend is present and when the underlying financial instrument shows more volatility.
Determining this value is one of the central functions of financial mathematics. The most common method used is the Black—Scholes formula. Importantly, the Black-Scholes formula provides an estimate of the price of European-style options. Adjustment to Call Option: When a call option is in-the-money i. Some of them are as follows:. Similarly if the buyer is making loss on his position i. Trading options involves a constant monitoring of the option value, which is affected by the following factors:.
Moreover, the dependence of the option value to price, volatility and time is not linear — which makes the analysis even more complex. From Wikipedia, the free encyclopedia.