A put option (sometimes simply called a "put") is a financial contract between two parties, the seller (writer) and the buyer of the option. The put allows its buyer the right but not the obligation to sell a commodity or financial instrument (the underlying instrument) to the writer (seller) of the option at a certain time for a certain price (the strike price). The writer (seller) has the obligation to purchase the underlying asset at that strike price, if the buyer exercises the option.
Note that the writer of the option is agreeing to buy the underlying asset if the buyer exercises the option. In exchange for having this option, the buyer pays the writer (seller) a fee (the premium). (Note: Although option writers are frequently referred to as sellers, because they initially sell the option that they create, thus taking a long position in the option, they are not the only sellers. An option holder can also sell his short position in the option. However, the difference between the two sellers is that the option writer takes on the legal obligation to buy the underlying asset at the strike price, whereas the option holder is merely selling his long position, and is not contractually obligated by the sold option.)
Exact specifications may differ depending on option style. A European put option allows the holder to exercise the put option for a short period of time right before expiration. An American put option allows exercise at any time during the life of the option.
The most widely-known put option is for stock in a particular company. However, options are traded on many other assets: financial - such as interest rates (see interest rate floor) - and physical, such as gold or crude oil.
The put buyer either believes it's likely the price of the underlying asset will fall by the exercise date, or hopes to protect a long position in the asset. The advantage of buying a put over short selling the asset is that the risk is limited to the premium. The put writer does not believe the price of the underlying security is likely to fall. The writer sells the put to collect the premium. Puts can also be used to limit portfolio risk, and may be part of an option spread.
Writing a put option - This is a graphical interpretation of the payoffs and profits generated by a put option as seen by the writer of the option. Profit is maximized when the price of the underlying security exceeds the strike price, because the option expires worthless and the writer keeps the premium.
Buying a put option - This is a graphical interpretation of the payoffs and profits generated by a put option as seen by the buyer of the option. A lower stock price means a higher profit. Eventually, the price of the underlying security will be low enough to fully compensate for the price of the option.
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