A put gives
- the owner (buyer) of the put
- the right (not the obligation)
- to sell the underlying (a given stock)
- at a given price (strike)
- before a given date (expiration date)
- In exchange, the owner of the call pays a premium to the seller.
As a buyer, you only have rights. It means that you decide what happens. The only risk you take is the option premium that you pay to buy the option contract. You can never loose more than this paid premium. It is your decision to exercise your right and actually sell the stock at the strike price, anytime before the expiration date (american style options only, this covers most stock and ETF. Indexes are usually european style)
when you buy a put option on stock ABC (the underlying) for a strike of 60€. Imagine that this trades for 0,5. The option expires on May 19.
This means that you have the right to sell ABC at a price of 60€ between now and May 19. Keep in mind the premium you paid. So, you will be getting in the end 59,5 for the stock ABC. (and the trading costs off course)
In the end you can compare this to an insurance. You pay a premium to insure the value of your items. When they are stolen or in an accident, your insurer pays you the insured value. When your stock would drop below the strike price, you get the strike price. No matter what the market wants to pay at that time.
Why buy a put option?
If you think that the underlying will go down, then you can buy a put option. With a limited investment – the premium – you could get great returns. Imagine stock ABC, worth now 60. You buy an option that expires one month from now at a strike of 55. You pay 1 for this.
If at the end of the month the stock is worth 50, then you just turned your 1 into 5.
you paid 1 for the option
You exercise your right to sell the stock for 55. As the market price now is 50, you could buy it back and make an instant 5 of profit. You just multiplied your investment 5 times. Keep in mind the trading costs
here is the caveat. The stock needs to be below 55 one month from now. If not, the options is worth 0€ to you. Imagine the stock is at 55,5 one month from now and then drops to 50 a week later. You lost your premium.
After the expiration date, you no longer have the right to sell the stock. You have now zero rights.