Image via WikipediaExample of a put option on a stock
Buy a Put: A Buyer thinks price of a stock will decrease.
Pay a premium which buyer will never get back, unless
it is sold before expiration.
The buyer has the right to sell the stock
at strike price.
Write a put: Writer receives a premium.
If buyer exercises the option,
writer will buy the stock at strike price.
If buyer does not exercise the option,
writer's profit is premium.
'Trader A' (Put Buyer) purchases a put contract to sell 100 shares of XYZ Corp. to 'Trader B' (Put Writer) for $50/share. The current price is $55/share, and 'Trader A' pays a premium of $5/share. If the price of XYZ stock falls to $40/share right before expiration, then 'Trader A' can exercise the put by buying 100 shares for $4,000 from the stock market, then selling them to 'Trader B' for $5,000.
Trader A's total earnings (S) can be calculated at $500.
Sale of the 100 stock at strike price of $50 to 'Trader B' = $5,000 (P)
Purchase of 100 stock at $40 = $4,000 (Q)
Put Option premium paid to Trader B for buying the contract of 100 shares @ $5/share, excluding commissions = $500 (R)
If, however, the share price never drops below the strike price (in this case, $50), then 'Trader A' would not exercise the option. (Why sell a stock to 'Trader B' at $50, if it would cost 'Trader A' more than that to buy it?). Trader A's option would be worthless and he would have lost the whole investment, the fee (premium) for the option contract, $500 (5/share, 100 shares per contract). Trader A's total loss are limited to the cost of the put premium plus the sales commission to buy it.
There is another related post about call options on this blog.