Buying put options

A put option provides the holder the right to sell a specified security at a specified price on a specified date. Note that while the call option is a right to buy, the put option is a right to sell. In exchange for this right to sell the investor pays a premium or price. A put option is favourable if the strike price is above the market price. In that case the capital gain upon expiration equals the difference between the strike price and the market price. If the strike price is below the market price, the put option has no value.

The following example shows how a put option may be used on the basis of expectations for the movements in the price of a share, a portfolio of shares or an index.

If the investor expects that the index value is going to fall from the present level 205, he can buy an index put option, e.g. with a strike price of 200. This option gives the investor the right, but not the obligation, to sell 100 times the index value at a price of 200. With an option premium of 7 per index value times 100 and an expiry price of 180 the investor’s capital gain may be calculated as follows:
 

If the expiry price is 200, the gain upon expiration is 0. Unlike the call option, the put option is said to be out-of-the money or in the money, if the price of the underlying asset is above or less than the strike price. Like call options, put options may also yield huge gains, while the maximum loss is limited to the size of the premium.

The figure shows the potential capital gain and loss upon expiration of the put option from the previous example. Please note that the loss is limited to the option premium already paid.