Understanding Profits and Losses from Buying a Put

A

The correct answer is A. Potential losses are limited to the initial premium the buyer pays when he buys the put.

When an investor buys a put option, they are purchasing the right, but not the obligation, to sell an underlying asset (such as a stock) at a predetermined price (known as the strike price) within a specified period of time (until the expiration date).

In this context, let's consider the profits and losses from buying a put option:

1. Potential losses: The buyer's potential losses are limited to the initial premium they pay when purchasing the put option. This is because the buyer has the right, but not the obligation, to sell the underlying asset at the strike price. If the price of the underlying asset increases above the strike price, the buyer will not exercise their option to sell, and the only loss they would experience is the premium paid for the put option.

2. Potential profits: The buyer's potential profits are not theoretically unlimited, as stated in answer choice B. When the buyer purchases a put option, they profit if the price of the underlying asset decreases below the strike price. The profit is realized by exercising the put option and selling the asset at a higher price than the market price. However, the maximum profit achievable is limited to the difference between the strike price and the asset's price at expiration, minus the premium paid for the put option.

3. Answer choice C, stating that potential losses are theoretically unlimited, is incorrect. As explained above, the buyer's potential losses are limited to the premium paid for the put option.

Therefore, the correct answer is A. Potential losses are limited to the initial premium the buyer pays when he buys the put.