Put Options

Definition

A put option is a type of option contract that gives the holder the right, but not the obligation, to sell a certain amount of an underlying asset at a predetermined price within a specific time period. Put options are primarily used to hedge against downside risk or speculate on a decline in the underlying asset's price.

5 Must Know Facts For Your Next Test

1. Put options allow the holder to profit from a decline in the underlying asset's price, as they can sell the asset at the higher strike price.
2. Investors use put options to hedge their long positions in the underlying asset, protecting themselves from potential downside risk.
3. The value of a put option increases as the underlying asset's price decreases, and vice versa.
4. The time value of a put option decreases as the option approaches its expiration date, known as time decay.
5. Put options can be used for speculation, where investors bet on the decline of the underlying asset's price.

Review Questions

• Explain how put options can be used to hedge against downside risk in the context of exchange rates and risk.
  • Put options can be used to hedge against the risk of unfavorable exchange rate movements. For example, if an investor holds a long position in a foreign currency, they can purchase a put option on that currency to protect themselves from a potential decline in the exchange rate. The put option gives the investor the right to sell the foreign currency at the strike price, limiting their downside exposure and allowing them to mitigate the risk associated with exchange rate fluctuations.
• Describe how the value of a put option is affected by changes in the underlying asset's price and the time remaining until expiration.
  • The value of a put option is inversely related to the price of the underlying asset. As the price of the underlying asset decreases, the value of the put option increases, as it becomes more valuable for the holder to exercise the option and sell the asset at the higher strike price. Conversely, as the price of the underlying asset increases, the value of the put option decreases. Additionally, the time value of a put option decreases as the option approaches its expiration date, a phenomenon known as time decay. This is because the likelihood of the option being in-the-money (i.e., the underlying asset's price being below the strike price) decreases as the expiration date approaches.
• Analyze how speculators can use put options to profit from a decline in the underlying asset's price in the context of exchange rate risk management.
  • Speculators can use put options to profit from a decline in the underlying asset's price, which is particularly relevant in the context of exchange rate risk management. By purchasing a put option on a foreign currency, speculators can bet on the depreciation of that currency against the domestic currency. If the exchange rate moves in the speculator's favor and the underlying currency's price decreases, the value of the put option will increase, allowing the speculator to sell the option at a profit. This strategy enables speculators to capitalize on their expectations of exchange rate movements without having to take a direct position in the underlying currency, thereby managing their exposure to exchange rate risk.

Related terms

Call Option: A call option is a type of option contract that gives the holder the right, but not the obligation, to buy a certain amount of an underlying asset at a predetermined price within a specific time period.

Underlying Asset: The underlying asset is the financial instrument (e.g., stock, bond, commodity) on which an option contract is based.

Strike Price: The strike price is the predetermined price at which the holder of the option can buy (call option) or sell (put option) the underlying asset.