A put option is a written contract between a seller and a buyer that gives the option buyer the right to sell an asset (typically a stock) at a certain price within a certain period of time. The buyer doesn't have to sell the stock during that time frame, but has the option to do so. The option seller, on the other hand, is obligated to buy the stock if the option holder decides to exercise his options.
Parts of a Put Option
The put option contract includes certain details. The strike price is the price at which the option can be
sold. The option premium is the price the buyer pays for the option. The expiration date is the date by
which the option must be used or it will become void. When the put option expires, the option purchaser can no longer sell the option at the strike price. Though the strike price is quoted per share, put options are sold in contracts representing 100 shares of stock each.
Option premiums are higher for longer expiration dates since there's a greater chance of the stock falling
over longer time periods. Option premiums are also higher when the strike price is higher than the
market value of the underlying stock.
Why Buy a Put Option
The put option buyer has the advantage of selling a stock for a higher price even though the price of the
stock has dropped as long as the option is exercised before the expiration date. Since the value of a put
option increases as the value of the stock falls, you would purchase a put option when you expect a
stock's value to fall. That's when an option contract is considered in-the-money and you can make a
profit. Of course, put options are less attractive when the value of a stock is expected to increase since
the value of the option will drop.
Selling Put Options
The seller of put options only makes money when the purchaser doesn't exercise the option before it expires. So, you would sell a put option when you think the stock price will either go up or remain the same. In that case, you'd never have to purchase the stock from the option buyer. Instead, you'd keep the option premiums as profit.
There is a confusing thing in this question if we are to selling a put option (an option that gives right the buyer of option to sell us underlying asset at strike price) how can we reduce our exposure by buying another asset? If we purchase an asset at a price say 10,000 and at the same time sell a put option at a premium of 500. The strike price of this option should be more than 10,500 otherwise the buyer of the option is not interested in buying the option. So the strike price should be say 10,700 and the value of the underlying asset in open market falls below the strike price and the buyer of option exercise the option we have to purchase another asset at the agreed price and the loss we suffer would be the difference between the strike price and the spot price. However, if we have already purchased an asset and than our intensions should be to earn profit because we hope that the price of the asset in open market will not rise above the strike price from selling options then we should sell call options (in this case covered call options).
If we want to reduce our exposure on the asset we already have we should buy a put option on that asset which gives us right to sell the asset at a certain price when the price in the open market falls below our tolerance level. In this case if the price of asset we purchased increases in the market we will not exercise out option to sell our asset and the option lapse and the maximum loss we have is the premium we paid for that option.
Q5
It's a generally accepted principle that prices will react immediately to changes in available information, whether public (e.g. new crop forecasts) or private (transmitted through the impact of transactions on the market.
Many finance theories predict that uninformed speculation should either not have any effect on price, or in less liquid markets, should not have a persistent effect…if uninformed trades do move a market price away from its fundamental value, informed traders, who know the fundamental value of the asset, will take advantage of the profitable trading opportunity with the result that the price will return to its fundamental value. So we can say that actions of speculators either by manipulating the liquidity or creating bubbles in trade have substantial effect on prices in financial market.
On the one hand, speculators can restore prices to equilibrium in market place; on the other hand, they increase volatility in the market place. One example of this is the roles speculators play in foreign exchange market. Private speculation can be stabilizing in that it is in the interests of speculators to move the exchange rate to its fundamental economic value. Speculators will attempt to buy the currency at a low value and sell it at a high value and in so doing reduce the gap between the low and high values. Since destabilizing speculation involves losses, there is every reason to suppose that private speculators will move the exchange rate towards its fundamental equilibrium value.
The Speculator's Role in the Capital Formation Process
The capital formation process involves the transfer of savings to investment through the movement of money from a surplus economic unit to a deficit economic unit. This process occurs in the financial markets, and these markets provide businesses with the ability to expand and grow, creating economic growth for society. The speculator provides liquidity and helps the markets to function more efficiently. In many respects, all investors and businessmen are speculators. By definition speculation is a business risk with the hopes of a gain or profit. The person who runs a business and assumes the risk to be in business is essentially a speculator because the outcome is uncertain. The investor that provides capital to businesses or the government in exchange for a return above inflation is also a speculator. The businessman, the investor, and the professional trader are all speculators who facilitate economic expansion.
The capital formation process could not occur without speculation, but it is the professional
trader, through the assumption of risk, who provides the balance of supply and demand as well as
liquidity and efficiency in the markets that move capital.
Speculator's Impact on World Markets
The world's financial markets were once separate entities. However, technology over the past 20 years, including the implementation of derivatives, has closed the gap between markets. All markets are now connected in some way, with geography and regulation no longer separating the boundaries of markets.
Currency traders move trillions of dollars around the world daily. This high volume can make or break an emerging market economy in the blink of an eye. Speculators have often taken the fall for the collapse of currencies in emerging markets such as the peso in Mexico and the Japanese government's inability to stop the collapse of the Tokyo stock market in the 1990s.
Speculation is a calculated business risk with the expectation of profit through the exploitation
of price volatility. Professional speculators are essential in providing liquidity and efficiency to
financial markets. They help allocate economic resources to their best uses through the art of
buying and selling financial assets and, by their volume of trade, provide liquidity to the markets.
This allows firms to hedge away risk and helps to lower the cost of capital, thereby facilitating
economic growth and improving the capital formation process. It is the speculator who warns
investors of weaknesses in markets and provides financial discipline throughout the world by
forcing financial law and order through pricing. Perhaps the most positive impact speculators have
on the capital formation process is the ability to place checks on governmental policy through the
buying and selling of currencies and bonds, thus preventing inflationary excesses. Speculation
does not come without dangers
