What Exactly Does a Put Option Agreement Mean?
A put option agreement is a contract that gives the buyer the right, but not the obligation, to sell a certain amount of a commodity, security, or financial asset at a prescribed price for a specified period of time. Corresponding to the term ‘put’ is the term ‘call,’ which refers to an option to purchase such a commodity, security, or financial asset. Thus, an option will either give to the holder a call or a put , but never both at the same time. Whether an option will be a call or a put depends on its particular purpose in a given context. When used in hedging, either may be used based on whether the hedger expects the value of the asset to increase or decrease; when used for investment purposes, a put option indicates a bet that the value of the asset will decrease. An option contract can simply be viewed as a bet or wager over the future price of an asset. Both put and call options are frequently traded on financial markets.
Defining Characteristics of Put Option Agreements
The put option is a derivative contract that gives the holder the right, but not the obligation, to sell the underlying asset or security at a specified price known as the strike price, and on or before a specified date known as the expiration date. In return for granting the put option the purchaser of the put pays a premium to the seller of the option. When a put option is exercised the seller must either deliver the underlying security or settle the difference between the exercise price and the current market price. The buyer of the put option pays a premium for the right to sell the underlying security at a later date for a specified price; thus drifting risk of a fall in the underlying security price to the seller. Put options, invariably used in the context of shares, give the investor long term downside protection in the market. Put options are more attractive than cash when it comes to insure the downside because put options tend to be cheaper than cash set against the downside risk. The cost of the put option premium can be financed by borrowing or the put seller may offer deferred payment terms. If the investor uses their cash to buy the put option, they will still need funds to purchase the underlying securities if the put option is exercised. However, if the investor borrows to finance the put option, they will incur some interest cost on the borrowings. So what happens when the underlying security falls beneath the strike price? The article below explains this in more detail. The timing and amount of the payable premium is determined by the factor – time value of money, in that the longer the period until the expiry date of the contract, the more valuable the put option will be. As with all option contracts, there are four key components to a put: The factors affecting the value of a put option include: the volatility of the underlying asset or shares; the risk-free interest rate; the dividend yield; and the time to expiration.
Advantages and Disadvantages of a Put Option Agreement
Investors often use put options as either a hedging tool or a speculative strategy. With regard to speculation, relative to other investing, the potential for leverage makes puts attractive since the investor does not "go all in" when buying an option. The earnings associated with put options can be significant. Likewise, the limited level of risk represented by the price of a put option contract makes them useful as a protective investment for the long term. For example, if an investor holds a stock that he or she believes is overpriced or recently went through substantial price swings but would not sell, it may be prudent for them to buy a put option as a form of insurance on the shares they own. In this way, the investor can offset a substantial fall in the market’s valuation of their stock which in turn would help mitigate the loss on the investment.
However, put options, like other options, also present risks. Many put option investors will choose to do so for the leverage by forgoing the full purchase price to buy the underlying shares at a later date. However, the possibility of a total loss on the puts exists. Likewise, if the put option was bought for speculation, the investor may lose their entire investment in the put if volatility in the market swings the investor’s intent in the opposite direction from a short position. Likewise, if an investor holds the option until expiration, his or her decision to do so may still result in a total loss on the put and even the face value of the put if the option does not carry a minimum exercise price.
Operations of a Put Option Agreement
Put option agreements are tools used by investors to protect against future declines in the value of their shares. At the time the parties enter into a put option agreement, the parties do not know what will happen to the value of the shares over the life of the put option agreement. By entering into a put option agreement, the shareholders can obtain some insurance against a decline in the value of their investment.
At the time the parties enter into a put option agreement, two things need to happen. First, the shareholders agree on a price for the shares subject to the put option agreement (the "Put Option Price"). An example Put Option Price would be the most recent round of funding. Second, the shareholders agree on a date on which the Put Option Price will be reviewed (the "Put Option Price Review Date"). An example Put Option Price Review Date would be 24 months after the date of the put option agreement.
Under a put option agreement, the other shareholders have, at the sole discretion of the shareholder that is selling its shares, the right (but not the obligation) to buy the shares subject to the put option agreement by paying the Put Option Price on the Put Option Price Review Date. If the shareholders agree on a sale price for the shares on the Put Option Price Review Date , the shares will be sold at that price. If the shareholders cannot agree on the sale price for the shares on the Put Option Price Review Date, the shares will be sold at the average share price of all the same class of shares issued in the previous 24 months. If there were no shares of the same class of shares issued in the previous 24 months, the shares will be sold at the most recent share price (or at an agreed upon price if there was no previous issuance of such shares).
Put option agreements usually have a life of 24 months. During the life of the put option agreement, if the shares subject to the put option agreement are sold, the same price as that agreed upon by the shareholders will be paid. In other words, a shareholder under those circumstances cannot hope to get a higher value for its shares than the additional value it hoped to get by entering into the put option agreement and, conversely, under those circumstances the other shareholders are protected against the risk of potential liability to the selling shareholder. When the shareholders enter into a put option agreement, they are setting a sale price for the shares (or at least a mechanism for determining the sale price), otherwise the agreement has no effect.
Understanding the Legal Mechanics of a Put Option Agreement
Put Option Agreements are subject not only to the statutes which govern the companies or entities involved but regulations governing share dealing and trading in securities. Under the Companies Act 1985 (the "Act"), section 182-184 govern issues relating to a company’s powers to purchase its own shares. The terms "put option" and "call option" are not defined in the Act but it is possible to infer their meaning from the provisions of the Act: a put option may be defined as a provision in an agreement which gives the option holder an entitlement to have the company acquire or redeem his shares for a specified period. A call option gives the option holder the right to sell his shares to the company within a specified period or to require the company to purchase them. It is important that any provision which confines the option period to a certain date be clear. In order to avoid conflict with s182 of the Act, it is advisable for such a provision to state that in the event that the window is missed then any subsequent exercise of the option must be in accordance with ss182-184 of the Act. Regulation 60(a) of the Companies (Share Capital and Premiums) Regulations 2008 states that a company may obtain as treasury shares either issued shares that it has purchased or acquired or shares that it has contracted to purchase under a put option in the money where the option has been exercised by the shareholder. When exercising its rights under a call option, a company may acquire its own shares under s694 of the Act rather than under s684. However, a company may not exercise a call option if the shares are either redeemable shares or redeemable convertible shares. Save for these exceptions, no other prohibition arises out of the Act as to the use of put or call options. The company may however pay more than the nominal value of a share for it when exercising its rights under a put or call option, but it is prohibited in pursuant to section 682 of the Act if payment for the share (after the said rate) would result in the issue of shares at a premium. Although it may be possible to have a call option which is conditional on a third party exercise, it is not possible to agree a put option conditional on the exercise of a call option. This is because of the statutory provision which prevents a company acquiring redeemable shares. There is also no statutory provision under s716 to allow a company to make a payment out of capital to redeem shares.
A Comparison of Put Option Agreements with Other Types of Option Agreements
Options exist in various types, all of which come equipped with their own unique attributes. Just as in other contracts, lawyers draft put option agreements to ensure that the rights and responsibilities between parties are clear and enforceable. Compared to other options, put option agreements can be a more complex choice for contractees and contractors.
A put option agreement is an arrangement between two parties whereby a purchaser has the right (but not the obligation) to sell a specified quantity of a given underlying asset to the seller after a certain time frame has elapsed or on a specific date. As per the sellers’ obligations under the agreement, sellers are required to purchase the specified quantity of the underlying asset from the purchaser, irrespective of the market price of the underlying asset at the time the put option is executed. The put option will require the seller to purchase the underlying asset at a pre-specified price (exercise price). This price will usually be determined when the put option is written.
The fact that the put option gives the purchaser the right and not the obligation to sell the underlying asset to the seller means that the risk of the price going down is borne by the seller, whereas the risk of the price going up is borne by the purchaser.
Put option agreements are not the only types of options available, however. A call option is another type of option agreement that exists between two parties. Where a put option agreement gives the holder the right to sell a specified quantity of an underlying asset , a call option agreement gives the holder the right (but not the obligation) to buy a specified quantity of a given underlying asset from the other party. The seller of the call option has the obligation to deliver the specified quantity of the underlying asset to the party purchasing the call option. The key difference between a put option agreement and a call option agreement is that the former gives the purchaser the right to sell an underlying asset, while the latter gives the holder the right to buy an underlying asset.
Put option agreements are not limited to obligations related to securities. Put options are often used in real estate transactions as well. For example, the purchaser of a put option could be given 24-months’ notice to give to the seller to buy a specified property at a pre-agreed purchase price. The purchaser in the put option agreement is protected from decreases in the value of the property (e.g., due to changing market conditions) as the purchaser would have the option to sell the property to the seller at the pre-agreed price during the specified 24-month period. Conversely, the seller of the put option is protected from increases in the value of the property as the seller would have the right to sell the property to the purchaser at the pre-agreed price.
A put option agreement can also reference public market assets, for example, the right to sell shares of a corporation or other securities, such as exchange traded funds, commodities (e.g., precious metals, oil and gas, etc.), and/or currencies.