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What is a Put Option and How Does It Work?


A put option is a derivative financial instrument that grants the buyer the right, but not the obligation, to sell an underlying security at a predetermined strike price within a specific expiration date. The counterparty of the option, known as the seller, commits to buy the security if the buyer decides to exercise their right. In exchange for this privilege, the buyer pays a premium to the option seller.

Practical Example:

Let’s consider security Y, which currently has a value of 5 euros. The buyer pays 0.50 euros to acquire a put option allowing them to sell the security at 5 euros within 30 days. If, after a month, the security’s value drops below 5 euros, it would be advantageous to exercise the option and sell the security at 5 euros, then repurchase it at a lower market price. If the security’s value drops below 4.50 euros, the transaction concludes with a net profit.

However, if after 30 days, the security’s value falls between 5 euros and 4.50 euros, a marginal loss will be incurred. In this case, the benefit of having the option will have been reduced by the premium paid to acquire it.

Use of Put Options in Derivative Contracts:

Put options form the basis for numerous derivative financial contracts. These contracts offer the right to sell the underlying security at a predetermined price and expiration date. Depending on the type of contract, the right can be exercised at various times: at the end of the contract (European option) or throughout the period until expiration (American option).

Derivative contracts traded via put options can involve different levels of leverage, depending on agreements with the broker. Leverage amplifies potential gains but also increases the risk of losses.

Conclusion:

Put options are powerful tools for risk management and speculation in financial markets. Understanding how they work and how they can be used in derivative contracts is essential for any investor or trader looking to capitalize on opportunities in financial markets.

di Il Quotidiano Online

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