Derivatives: Put Options(3)

A put option is a contract in which the long has the right to sell a stock to the short at a predetermined price called the exercise price, regardless of the market price at a predetermined date. A put option is a classic example of an insurance strategy. It is used to protect or hedge against the risk of losing value in a stock held in a portfolio. I am going to use another example to illustrate the use of options in a stock market.

Mrs. Green has Dunlop shares in her portfolio from the public offer she bought a few years ago and she is worried that the company is going to face a lot of economic troubles due to the present difficult manufacturing terrain in Nigeria. She cannot sell because there is illiquidity in the market at the moment and she has an opportunity to use a put option. Let us assume that Dunlop is going for N2.50 per share and she was able to get a deal with Prof Brown, who believes that since Dunlop has decided to diversify into real estate and trading of tyres, the company stock will still remain valuable.

Mrs. Green decides to buy a put option, which will cover 1000 units of Dunlop. Prof Brown writes a European put option, which Mrs. Green buys. This means that Prof Brown is the short (insurance investor) and Mrs. Green is the long (insured investor). The contract has an exercise price of N2.30 and an option premium of 30K to expire in 30 days. What this means is that Mrs. Green will pay Prof Brown N300 (30K x 1000 units) at the initiation of the contract with the understanding that Prof Brown has an obligation buy 1000 units of Dunlop from Mrs. Green at the end of 30 days at N2.30 per share if Mrs. Green is still interested in selling them.

At the end of 30 days, there are two possible scenarios that can play out. One, the price of Dunlop will be more than N2.30 and two, the price of Dunlop will be equal to or less than N2.30.

In the first scenario, since Dunlop is more than N2.30, Mrs. Green will not be interested in selling them to Prof Brown because if she does that, she will invariably give out the asset and receive less than its value. So the option will expire worthless and will not be exercised.

In the second scenario, the option will be worth N2.30 minus the current value of the stock price. Assuming Dunlop stock price has fallen to N1.50, Mrs. Green will be very happy to sell them to Prof Brown at N2.30, netting an 80K gain with a 50K profit after subtracting the cost of the contract of 30K per share.