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Put Option

A put option is a financial derivative that gives the holder the right (but not the obligation) to sell the underlying stock at a pre-specified price (the strike price) at any time up to the day when the option expires (the expiration date). In general, the purpose of a put option is to protect oneself from declines in the underlying stock price. One particular use of a put option is called the protective put. Such a put combined with being long equivalent number of shares in the underlying stock has the effect of neutralizing downside exposure, while leaving open the potential upside.

In addition to usage as insurance, put options can be bought and sold without attachment to the underlying stock (similar to call options). Investors and speculators who are bearish on the stock but don’t want to put up the entire amount up front can buy a put option for the right to sell the stock at some later date. If, during the time the option is alive, the stock moves in your favor (down), you can exercise it and sell the stock at the pre-specified strike price. Thus, if you bought the stock at the current, lower price, then sell it immediately, you will profit by (K – S), less commissions.

The payoff diagram for a put option looks like this:

Put Option Payoff at Expiration

In the example payoff above, the call pays nothing down to the strike price at 15, after which the option is in the money and will increase in value as the underlying stock continues to advance. Note that the diagram is only valid for the payoff at expiration. Prior to expiration, the option is worth more due to time value.

The long put option is considered to be limited risk, because you can only lose the full amount of what you put in. The naked short put option has a payoff that is the mirror image of the long, and therefore has theoretically unlimited risk. Unlike a naked call, a naked put really is limited since stock prices cannot go below 0.