A put option primer
Put options are derivatives that give you the right, but not the obligation, to sell an asset at a predetermined date at a specific price. These are used for different kinds of assets, including stocks, commodities, minerals, energy products like petroleum, and so on. Derivatives were introduced in the Indian stock markets in 2001. Today, the Securities & Exchange Board of India (SEBI) offers future and options on 175 specified securities. There are two types of options available for trading – call and put options, each with unique purposes.
What is Put Option?
A put option is a financial contract that gives the holder the right, but not the obligation, to sell an underlying asset (such as a stock) at a specified price, called the strike price, within a predetermined time frame. It is commonly used in options trading and is a tool for hedging or speculating on the decline in the price of an asset.
If the asset’s price drops below the strike price, the holder can sell it at the higher strike price, making the put option profitable. Conversely, if the price stays above the strike price, the holder may let the option expire, only losing the premium paid for purchasing it. Put options are essential in risk management, allowing investors to protect against downside market movements.
How Do the Put Options Work?
Put options work by gaining value when the price of the underlying stock or asset decreases. If the stock price falls below the strike price, the put option becomes more profitable.
On the other hand, if the stock price rises, the value of the put option decreases. This makes put options useful for protecting against losses or speculating on a price drop.
A common risk management approach involving put options is the protective put, which acts like insurance for investments. This strategy limits potential losses on an asset to a specific amount.
Investors holding a stock can buy a put option to protect against a price decline. If the stock price drops, they can sell it at the strike price. If they don’t own the stock, exercising the put creates a short position.
Buying a Put Option
Investors purchase put options as a form of protection for their other investments. They typically buy puts that match the amount of the asset they own. If the asset’s value falls, they can sell it at the predetermined strike price. Put buyers gain by effectively maintaining a position similar to short selling.
The profit for a put option holder comes when the asset’s price falls below the strike price before the option expires. During this period, the put buyer can sell the asset at the agreed strike price.
For example, imagine ABC Company’s stock is priced at ₹50. Put options with a strike price of ₹50 cost ₹3 each, with one put representing 100 shares, so one put costs ₹300 and expires in six months. John buys one put option for ₹300, hoping that ABC’s stock price will decrease. If the stock price drops to ₹40, John can use his put option to sell the stock at ₹50, making ₹1,000 (100 shares x ₹10). After deducting the ₹300 cost of the put, John’s net profit is ₹700. However, if the stock price stays above ₹50, John loses his ₹300 investment.
Selling a Put Option
Investors can also profit by selling put options. Put sellers aim to earn from the premiums paid by the buyers, betting that the options will depreciate.
After selling a put, the seller must buy the asset at the strike price if the buyer exercises the option. The put seller profits if the asset’s price stays the same or rises above the strike price.
If the asset’s price drops below the strike price before the option expires, the put buyer profits by exercising their right to sell. In contrast, the seller faces the obligation to buy at the higher strike price. If the price remains the same or higher, the put seller keeps the premium, but the buyer doesn’t profit.
Put vs Call Option
Which is better for trading – put or call option? The answer to that question is not all that clear-cut. It all depends on your risk tolerance, the situation in the market, and your investment goals. If you expect prices of stocks to fall, then put options are a better choice. If prices are expected to fall, then you might be better off with call options.
How To Trade Put Options in India?
Now that you have understood what a put option is, you can go ahead and trade in them. Derivatives like put and call options are available on stock exchanges like the Bombay Stock Exchange and the National Stock Exchange. You can buy and sell futures and options through your broker, just like any other share. You can buy put and call options in indices like the Sensex, the Nifty and other sectoral indices. However, you must note that cannot trade in derivatives on all stocks. They are only available for about 175 shares listed on the exchange.
FAQ:
What happens when you execute a put option?
If you are the buyer, you sell the stocks to the writer or seller at the strike price. The seller is obligated to receive the asset if the buyer decides to exercise his right. If the contract expires unprofitable, nothing happens, and the seller gets to retain the premium.
When should you exit a put option?
When you are holding a put option, you actually have the choice to quit it early. Put options, unlike futures, doesn’t require you to follow the contract. The right time to exit a put option will depend on your position, that is whether you are a buyer or seller. One standard method to exit an option is to offset. You can sell put option that you have previously bought or repurchase put option that you have previously sold before the expiry date. Unless you offset an option, you haven’t officially exited the trade.
What happens if we don’t sell options on expiry?
If you don’t exercise an option, it expires out of money or OTM. When the strike price of the option is higher than the current market price, the option expires as OTM for the seller When the strike price is lower than the market price, it becomes an OTM for the buyer. If you are the seller of the option, you get to retain the premium.
Is it better to exercise an option or sell it?
You exercise an option when you want to buy or sell the underlying asset. But in most cases, options aren’t used even when they are profitable.
How much can you lose on a put option?
If you buy a put option, your loss will depend on the stock price movement – if the stock price falls substantially below the strike price, as a put buyer, you make a profit. But if stock prices move in the opposite direction, you lose. So, as a buyer, your loss from the put option also gets magnified by the movement in stock price. For a put seller, the maximum gain is limited to the premium paid. But on the downside, the loss amount is theoretically infinite.
Can you exercise a put option before expiration?
Exercising a put option before expiration is possible but rarely happens because the value of the option is directly related to extrinsic market factors – underlying asset, the dividend paid, and more. If you want to exit a put option before the expiration date, you need to opt for ‘sell to close’ to secure some profit.
Only sell a put option if you are interested in owning the underlying
Enter the deal only if the net price of the underlying is attractive
You can keep the entire premium if the option expires OTM
You can own an underlying below the market price
Selling put allows you to buy attractive stocks at a price that is below the market price.
Is selling puts a good strategy?
Selling a put option is a good strategy, but it’s prudent only in the following situations.
How do you profit on a put option?
Several profit-loss situations can arise during a put option trading. As a put option buyer, you profit from exercising the option when the stock price falls below the strike price. The profit from a put option is the difference between the strike price and the premium paid. Higher the resultant value, higher is your profit.
What to do after you buy a put option?
Here are a few things you can do. If the underlying tanks you exercise rights and bag profit If the underlying price rises and you let the option expire, you lose the premium paid You can also offset and exit the trade.
Is a put option a short?
Short put option meaning, writing a put option or agreeing to buy an underlying at a pre-decided price on the expiry date. A trader opens a short put when he believes the stock price to remain higher than the strike price. A short put is when the put is uncovered, also called naked put. The substantial loss arising from the short put, if the buyer chooses to exercise his rights, can be substantial. On the other hand, the profit margin is limited to the premium received.
