Posted on October 15, 2010 by Rich Browne

A put option is a contract designed for a subscriber of an option to sell a security or other asset (the underlying) at a predetermined price (exercise price) on a specific date known as the maturity date. It allows the buyer of the put to hedge against, or bet on a decline in the price of the underlying security.

Premature exercise of the option is mostly due to the disadvantage of the remaining time value. Upon exercising you obtain only the intrinsic value, plus time value. In practice, an exercise can still be useful if the option for either the market price is offered or the bid-ask spread is greater.

The first goal of these put options is to protect against declining prices of the underlying. For example, the purchaser of a share, buying a put hedges against a drop in the the exercise price. The put acts as an insurance, hence the name given to its premium price.

The option also allows the purchaser to speculate on the decline of the underlying, limiting the risk, since only the premium is engaged. In contrast, the speculator who wishes to sell a put option estimates that the price of the underlying does not fall below the exercise price by the due date.

Buying or selling an option, put or call, is a way to speculate on the volatility of the underlying asset: the buyer speculates on its appreciation and while the seller anticipates a decline.