In this article we will illustrate what is a put option by using an example of a potential house seller in order to explain options in more common terms. If someone understands the house example below then he/she understands how put options are fundamentally working.
Suppose that George is the owner of a house. He agrees with Mary to sell his house to her after a year at the price of $200,000. In their agreement George has the right but not the obligation to sell his house at a predefined price one year later and he must pay Mary some money in order to have this right i.e. $5,000. Mary takes this money and keeps them, no matter what will happen after one year. She will not return them to George but she is obliged to keep the agreement if asked by George. The market price of the house the day of the agreement is $210,000. So after a year what might have happened?
Case 1 : The market value of the house will be $170,000. George exercises his right to sell Mary his house at the predefined price of $200,000. His choice was profitable because if he would like to sell the house now without having booked a price, he would have earned $170,000 (its present market value) which is $30,000 less than the predefined price of the agreement. But Mary on the other hand didn’t make a wise choice because if she hadn’t agreed with George to buy his house she could buy another house at market prices after a year at $170,000 instead of $200,000. So Mary sold this right because she believed that house prices will go up and George bought this right because he thought that house prices will be down after a year.
Case 2 : The market value of the house is $240,000. George has no interest to exercise his right to sell his house at $200,000 because he can sell it at market prices much more expensive, at $240,000. So his right is expiring worthless. Mary on the other hand is not buying his house at $200,000 because George didn’t exercise his right against her. The advantage for Mary was the $5,000 she took from George.
If you understood the above example you know how a put option is working. All you have to do is replace the word ”house” with the phrase ”100 stocks”. Let’s make the analogies:
1. Mary is the seller (writer) of the put and George is the buyer
2. The $5,000 that George paid in order to have the right is the premium
3. The predefined price of $200,000 is the strike price
4. The expiration of the option is one year from the agreement
5. The underline asset is the house
In real option markets instead of exercising the right a buyer can sell the same option in order to close the position and take profit from the higher premium in which he/she will sell it (see page ”Trading options”).
Conclusively, a put option gives its buyer the right but not the obligation to sell the underline asset in a fixed date in the future at a predefined price, whereas it gives its seller the obligation to buy the underline asset in a fixed date in the future at a predefined price if the right is exercised against him/her.
The buyer of the put wants the price of the underline asset to be lower because she has booked a selling price, whereas its writer wants the price of the underline to be higher in order not to be exercised against him and earn as much as he can from the premium.