A put option gives the holder the right (not the obligation) to sell a specified quantity of the underlying at a specified strike price by a specified expiration date.
An issuer sells a put option granting the holder the right to sell 100 shares of a certain stock at £10 each by a specified expiration date. If, on the expiration date, the stock were trading at £15, the holder would decide not to exercise the option, since they would be selling a stock worth £15 for £10, effectively losing £5 for each stock sold. The put option is useless and the holder loses the premium paid to the issuer for the option.
If, on the other hand, the stock were trading at £5 on the expiration date, the holder would exercise his option, selling total shares worth only £500 for £1000.
A graph of profit / loss against value of stock at expiration:
| \ |
| \ |
| \ |
profit | \ |
/ 0 |______________\__|________________
loss | \ | } option
| \|________________ } premiun
value of stock at expiration
Obviously the holder
wants the stock to be worth less at the expiration date
than the strike price
, set when the option
A European put option can only be exercised at the expiration date, whereas an American put option can be exercised at any point before the expiration date.
I've used £s throughout as I am British, don't you know
. Obviously, everything works just as happily with $s. Or ¥ or €s for that matter...