A put option is the opposite of a call option—and if you don’t know what that is, see my previous post What Is a Call Option? This post uses a fictional scenario to illustrate the basics of what a put option is. I do not get super detailed here, but links to more in-depth resources can be found at the end of the post.
Lets Get Started
I have a nice Apple laptop with all the bells and whistles that I paid up for in part because Apple products are known to have good resale value. I plan to retire within a year (woot!) and because I will not need the laptop anymore I hope to sell it and recoup most of my money. My target is to sell the laptop for 80% of the price I paid for it—but I am afraid that Apple might release a new line of laptops, which would accelerate my laptop’s value decline such that I could only get 50% or less. I consult with my investor friend Tim and he does not think a new line of laptops is likely in the next year. Though Tim believes I am safe, I am still not sure and wonder if there is a way to protect myself.
It turns out that Tim is very confident in his prediction and sees an opportunity to make some money so he offers me a deal: if I pay him a $100 fee today he will buy the laptop from me anytime in the next year for $1,600—or 80% of the $2,000 I paid. This deal (or contract) is called a put option and it gives you the right to sell something at a set price in the future in exchange for a fee.
The Put Option Details
Tim is betting that the value of the laptop will not drop by 20% within the next year. If the value drops by only 10% to $1,800, I will choose not to exercise my put option to sell the laptop to Tim for $1,600 because I can sell it to someone else for $1,800. I would, however, lose the $100 I paid Tim—which he would pocket as profit—and our put option would expire.
But as in the case of the call option, more than one scenario is possible. If Tim is wrong and Apple does announce a new line of laptops, overnight the value of my laptop might drop by 50% to $1,000. The good news is that because I have a put option contract with Tim, he would be obligated to buy it from me for $1,600—which is $600 more than it is worth. And though I would pocket $600 more than I could have gotten if I had sold it to someone else, my total profit would be $500 ($600 less the $100 fee I paid)—that is, the gain over the market value minus what I paid for the option.
Want to Know More?
Put options are mostly used in the stock market against a stock (rather than a laptop), but they can be used in any type of transaction. The following links are good resources for learning more about put options: