Monday, December 21, 2009

(110)---PUT OPTION

Put Option

A put option is a contract that gives the holder a right to sell a specific share or any other asset at an agreed exercise price on or before a given maturity period.

Suppose you expect price of company Y share to fall in the near future. Therefore, you buy a 3 month put option at an exercise price of 50$. The current market price of company Y share is 48$. If the price actually falls to 35$ after three months, you will exercise your option. You will buy the share for 35$ from the market and deliver it to the put option seller to receive 50$. Your gain is 15$, ignoring the put option premium, transaction cost and taxes.

You will forgo your put option if the share price rises above the exercise price; the put option is worthless for you and its value is zero. A put buyer gains when the share price falls below the exercise price. Ignoring the cost of buying the put option called put premium, his loss will be zero when the share prices rises above the exercise price since he will not exercise his option.

Put option pay off

An investor hopes that the price of company Y share will fall after three months. Therefore he purchases a put option on company Y share with a maturity of three months of premium of 5$. Then exercise price is 30$. The current market price of Company Y share is 28$. How much is profit or loss of the put buyer and the put seller if the price of the share at the time of the maturity of the option turns out to be 18$, or 25$, or 28$, or 30$, or 40$?

The put option buyer s maximum loss is confined to 5$ that is the put premium. His profit equal to exercise price less the sum of share price and premium. Since the share price cannot fall below zero, he has a limited profit potential. The put buyer will always exercise his option if the exercise is more than the share price. His break even share price is 25$ that is the exercise price premium.

For the seller of a put option, the profit will be limited to 5$ the amount of premium. His loss potential depends on the price of the share. But it cannot exceed 25$ that is the difference between the exercise price, 30$ and the premium 5$.

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