Posted on October 15, 2010 by Rich Browne

The seller of the put option is obliged to purchase the underlying security. For this obligation, the seller receives the option premium from the buyer of the option. The buyer of a put option will exercise his right only if the price falls below the exercise price of the underlying asset.

In practice, the underlying security is not necessarily delivered upon exercise of the option. Instead, the buyer simply pays the difference between the exercise price and the price of the underlying at the time of settlement – a practice known as cash compensation. Whether a cash settlement takes place or the underlying is delivered, the terms around such events are all set in the contract.

Buyers of put options are also in a position to gain from the capacity to trade the underlying instrument at an inflated price (proportional to the current market value) and buy back their position at a lower current market price.

The valuation of a put before the maturity date is not easy since one must estimate the value of the underlying in the future. Nevertheless, the most common method used is the Black-Scholes model.

If the underlying is a share of a listed company issuing the dividend payment, the issuer generally anticipates lower mechanical share price equal to the dividend by integrating an additional parameter in their valuation model.