Nested Interest

A put option is a derivative security that grants to owner of the option the right to sell a specified amount of an underlying security at a specified price (the “strike price”) at a specified time (the “exercise date”).

By owning a put option on an underlying investment, a payoff from put option will occur if the price of the underlying investment is less than the strike price of the option when the option is in effect.

The payoff of a put option is illustrated below:

As the payoff structure illustrates, the holder of the put option receives a payoff when the price of the underlying investment is less than the strike price; however, if the price of the underlying investment exceeds this amount there is no payoff.

Notice that the payoff structure is single-sided – that is, it has a positive payoff when the price of the underlying investment is less than the strike price, but no loss if the prices is above the strike price.  This is because, as its name implies, the purchase of the underlying investment is optional to the holder of the option, therefore the holder of the option will only exercise this right when it is in his/her financial interest to do so.

Because of this single-sided payoff, a put option has value and must therefore be acquired at a price.  The price of a put option is dependent upon a number of factors, including:

The current price of the underlying investment - the lower the price of the underlying investment, the more valuable the put option

The strike price - the higher the strike price, the more valuable the put option.

The exercise date - the later the exercise date, the more valuable the put option (this phenomenon is often referred to as the time value of the option)

The volatility of the underlying investment - the more volatile the underlying investment, the more valuable the put option (as there is a greater probability that the price of the underlying investment will move to a point below the strike price).

The prevailing risk-free interest rate - the higher the interest rate, the lower the value of the put option.