A put option is an option contract in which the holder or buyer has the right, but not the obligation, to sell a specified quantity of a security at a specified price within a fixed period of time, that is, until the expiration of the option. The price at which the stock can be sold is known as the strike price. No new stock is created in the transaction. The seller of a put, also known as the writer, has the obligation to purchase the underlying security at the strike price if the option is exercised. The put option writer is receives the cost of the option, or premium, for taking on the risk associated with the obligation.
Options can be traded on a range of underlying instruments such as indices, commodities, FOREX and equities. In the U.S., the option contract most often refers to 100 shares. As long put positions can be used for downside protection of an asset, they are commonly used in risk reversal strategies.
Note how the mechanics of this instrument are the exact opposite of a call option. In this case, the holder of the put may sell the stock, whereas the holder of a call option has the right to buy the stock. This leads to put-call parity where the purchase of a put combined with the shorting of a call on the same strike with the same expiration is EQUAL to a short position in the underlying stock.
Put Option Example
There are many strategies available to traders when using options in trading merger arbitrage or as part of a wider investment strategy. We discuss these strategies in our article How to use Options in a Merger Arbitrage Strategy. The following example is taken from that article.
Sell Puts
Selling target puts in lieu of buying target stock enables the trader to collect time premium as well as profit from the movement in the spread. As expiration approaches, whilst below the offer price the ITM put starts to behave like stock. As the target stock moves up the option hopefully expires worthless. The opportunity cost of collecting this option decay is foregoing any higher bid as there is effectively no position above the strike price of the put. If the spread does not move up to the strike before expiry, the position can be rolled to the next expiry and avoid taking possession of the actual stock. Selling put options with a lower strike than the offer price may result in higher option decay but increases the chance the stock may finish higher than the strike price – a difference in movement for which the trader will not be rewarded.
This strategy can only be done on a cash deal where the offer price is fixed. In a stock deal the trader would be indirectly selling a put on the acquirer stock and be exposed to market forces acting upon that stock. Therefore, even if the trader was short the required quantity of acquirer stock, as per the exchange ratio, the trader would be constantly re-hedging the target position and would endure the P&L profile of a short gamma position.
Additional Traded Options Resources
- Often considered obligatory reading for options market-makers is Option Volatility and Pricing: Advanced Trading Strategies and Techniques, 2nd Edition by Sheldon Natenberg
- For more on the topic of volatility, see Kevin Connolly’s book Buying and Selling Volatility
