Question

(7) Explain how a put option works. What are the rights and obligations of cach party to a put option contract? Are the rights and obligations symmetric? Provide an example of a put option being used to insure against the risk of price movements in the underlying security (8) Compare the benefits and costs of buying a put option versus selling in the futures market when trying to protect against the risk of price changes in the underlying security.

Answer 1

7. A put option giver the buyer the right to sell the underlying at the strike price on the date of maturity and the seller the obligation to buy the underlying from the put option buyer at the strike price if the option buyer decides to exercise the option.

Thus here the rights and obligations are not symmetric in nature as the buyer has the right to exercise the option or ot while the option seller has no right and only obligation to buy the option depending on the option buyers decision.

Now if the stock A is trading at $50 as in today. An investor owns this stock and plans to sell it in 3 months but is unsure if the stock price will remain at the current price and wants to receive at least $50 in 3 km this for this stock. Then he will purchase a put option of strike $50 maturity 3 months for a option premium $x. Now 3 months from now, if the stock price increases to more than $50 to let's say $70, the investor is anyway getting more than the minimum he wanted (more than $50). Now if he exercises the option he will have to sell for $50 when he will get $70 in market. As he has the option to choose, he will go will selling in market for a higher price than exercising the option.

Now if the stock price has decreased to $30, he will get less price in market. Rather it makes more sense for him to exercise his option as he can now sell for $50 as per the option contract.

8. Buying a put option gives the investor the option to exercise the option and sell for the strike price or not depending if the price of option after 3 months as mentioned above. Buying a futures to sell at $50 locks in that price and irrespective of the stock price in 3 months, the investor will have to sell for $50. Thus if there is a price gain in 3 months (if stock price increases to $70, he can use this gain for making profits).

For the above flexibility to choose to exercise the instrument or not, there is an extra premium amount an put option owner has to pay, which the future owner does not have to. Thus cost and benefits are higher for put option owner than a future owner