Puts are, simply put, insurance (pardon the pun). You pay a premium for the option to sell the stock to someone at $X at a future date. Let's say you think that AAPL is going to go down in price. You could for example buy a put option to have the option to sell AAPL stock at $118.28, in 6 months, to the person who sold you that option. If the stock goes up, you don't exercise the option. If it does, the option writer (guy who sold it to you) pays you the difference between the stock price at that time, and $118.28. The only cost to a put option is the premium (maybe a few dollars, depending on the forecasted price of the stock and forecasted interest rates) that you paid at time 0. So if you paid $10 for the option, and the stock goes down to $105, your total cashflow is +$3.28. If the stock went up to $200, your total cashflow is -$10.
Indeed. it was an Explain Like I'm Five explanation. I have learned far more than I've ever cared to learn about pricing options. Actuaries get paid well in part because the exams are difficult. :)
Also, the timing is only applicable to European options which expire on a specific date. American options have no expiration date!
> Also, the timing is only applicable to European options which expire on a specific date. American options have no expiration date!
Umm, American options still have an expiry date. They can be called earlier than their expiration date, though unless there is a dividend to be paid, its never advantageous to do so.
But American options absolutely have an expiration date. They wouldn't make sense otherwise.
I mean at price would you sell someone a put or a call if they could wait forever to exercise it?
No matter what implied vol you put on the underlying, you would still have to price it at infinity wouldn't you?
