Put options - Protect Assets From Dropping in Price
Ever turn down an offer from someone to buy one of your prized possessions, only to decide later that you do want to sell it, but you can only get 75% of that original offer? It hurts, and you live with that regret. But there’s a financial tool that can help you prevent this scenario with your FX risk. It’s called a put option.
What Is a Put Option?
Put options are financial derivatives that give the purchaser the right to sell an item at a set price for a preset amount of time. The put purchaser pays the seller a premium (fee) for this right. The purchaser has the option but no obligation to sell the asset. In contrast, the option seller must buy the item at the set price for the duration of the option’s life if the seller decides to follow through with the contract.
Put at an Advantage
The primary use of put options is protection against downside risk. In the FX market, they protect you against dropping currency prices. You pay for the right to have that option, but the premium is the most you forfeit if you decide not to exercise that right. Put options can be either exchange-traded or OTC (over-the-counter, privately negotiated).
PUT Option Example
Let’s say you’re in the market for a new car you hope to purchase within the next six months. You are planning to sell your current car when it comes time to buy the new one. In the meantime, your car’s value is dropping daily. What if you could pay a small fee (premium) to lock in your car’s current value with an option to sell it at that price anytime in the next six months? So no matter how low the value of your car drops in the next six months when you’re ready to sell it, you have a buyer who will pay today’s locked-in price. If your plans change and you decide to keep your car, you only forfeit the premium. That’s how a put option works.
Put options are financial derivatives that give the purchaser the right to sell an item at a set price for a preset amount of time.
Currency Put Options
If you purchase a put option for the right to sell euros at $0.99, you retain that right even if the euro drops to $0.85 (or lower). If the market value of the euro is above $0.99, you don’t need to exercise the right to sell. The only thing you lose is the premium you paid to acquire the put option.
Put the Conclusion Here
Put options are an effective way to hedge against downside risk. They are a valuable product to aid in protecting cash flows from foreign countries. The opposite of a put option is a call option. Check out our article on call options to learn more.
Takeaways
- Put options are financial derivatives that give the purchaser the right to sell an item at a set price for a preset amount of time.
- You pay a premium (fee) for the right to sell, but you have no obligation to do so.
- The primary use of put options is protection against downside risk.
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