How can an investor sell stock after purchasing a put option when the value of the stock dropped?

If an investor buys a put option for the right to sell shares at $50 a share, and the market price of the stock drops to $40 per share, how is it possible the investor is able to exercise their right to sell the shares at $50 per share? Who would be interested in purchasing stock at $50 per share if they can purchase it for $40 per share?

You are correct that no one would want to pay $50 per share for a stock that they could buy for $40 per share on the open market, but when someone sells a put option they understand and accept that (1) that may happen and (2) the decision is up to the holder of the option.

You should also understand that it is quite likely that the person who wrote the put option did so as part of a spread. For a fairly simple example of a spread trade I did earlier see

http://messages.yahoo.com/Business_%26_F...

In that example I bought AMGN stock for $62.50 per share when it was trading for less on the open market, but I still ended up with a small profit.

Entering into an option contract allows the buyer to call for specific performance of the seller just as outlined in your queston. This is the risk that sellers of options are willing to take.

The option contract is legally binding contract between buyer and seller.

The put option is a legal contract between the seller of the option (e.g. a bank) and the buyer (the person with the right to sell). The buyer pays a premium to the seller for this right.

Thus, if the buyer / holder of the option has the right to sell shares to the seller at $50, the seller must buy at that price if the buyer exercises the option within the terms of the contract. {The seller will hedge this market risk, usually in bulk, with another bank in the same way that a bookmaker lays-off some of its risk}.

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