Investing is often perceived as a straightforward endeavor: buy low, sell high. However, delving into the realm of investments reveals a landscape rife with complexities and nuances. For novice investors, the sheer multitude of investment instruments and tools can be overwhelming. Moreover, navigating the ever-changing market dynamics requires vigilance and adaptability.
Beginners quickly realize that successful investing entails more than mere luck or intuition. It demands a comprehensive understanding of economic, political, and social factors that can influence market trends. Moreover, mastering various investment instruments is crucial for making informed decisions and maximizing returns.
Among the myriad investment options available, derivative contracts like Put Options stand out for their potential to enhance investment strategies. Put Options provide investors with the right, but not the obligation, to sell an asset at a predetermined price within a specified timeframe. Understanding how to leverage Put Options effectively can help investors protect their portfolios from downside risks and capitalize on market downturns.
In essence, successful investing requires continuous learning, adaptability, and a keen understanding of the diverse array of investment tools available. Put Options represent just one facet of the intricate world of investments, offering opportunities for savvy investors to navigate market fluctuations and achieve their financial goals.
| What is a Put Option? |
| How a Put Option Works? |
| Factors that Affect a Put Option’s Price |
| Benefits of Put Options |
| Understanding Put Options with Money |
| Long Put vs Short Put |
| When to Buy and Sell a Put Option? |
| The Payoff for a Buyer and Seller of a Put Option |
What is a Put Option?
A put option is a contractual right allowing an investor to sell shares of an underlying security at a predetermined price within a specified timeframe. Contrary to call options, put option buyers hold a bearish market sentiment, anticipating a decline in stock prices.
By acquiring put options, investors wager on potential decreases in stock prices, aiming to capitalize on this outlook. This strategy is commonly employed as an alternative to owning actual stocks. For instance, if an investor anticipates a decline in a particular stock’s price within a specific timeframe, they may opt to buy put options, enabling them to sell shares at a predetermined price by a specified date.
The agreed-upon selling price in the put option contract is termed the strike price, while the cost of the option contract itself is referred to as the premium. Essentially, purchasing a put option entails transferring the obligation to buy shares of a security at the strike price to the counterparty, rather than at the prevailing market price.
In trading put options, investors speculate that the underlying asset’s price will decrease by the contract’s expiration, enabling them to sell shares at a higher price than the market value, thus yielding a profit.
How a Put Option Works?
In the realm of options trading, put options gain value when the price of the underlying asset decreases, while they depreciate when the asset’s price rises. They’re often enlisted for hedging or speculating on downward price movements.
- Buying a put option signifies a belief that the underlying stock’s value will decrease during the option’s duration.
- Selling a put option reflects a belief that the underlying stock’s value will either appreciate or remain constant throughout the option’s duration.
One prevalent strategy employing put options is the protective put, serving as a form of investment safeguard or hedge against potential losses beyond a predetermined threshold. Here, investors mitigate downside risk associated with a portfolio’s stock holdings by acquiring put options. Upon execution, these options enable the investor to sell the stock at the predetermined strike price, effectively limiting losses.
Alternatively, investors lacking ownership of the underlying stock can utilize put options to establish a short position in the stock. By exercising the put option, they commit to selling the stock at the strike price, thereby profiting from potential declines in its value.
Factors that Affect a Put Option’s Price
Various elements affect put options, including stock price, strike price, volatility, time to expiry, and interest rates. Falling stock prices benefit put options, while increased volatility favors put option buyers. Rising interest rates typically hurt put option prices.
As the clock ticks towards expiration, the value of put options typically dwindles due to time decay. This decay hastens as expiration approaches, leaving only the intrinsic value, representing the difference between the strike price and the underlying stock price. Options with intrinsic value are deemed in the money (ITM).
Out-of-the-money (OTM) and at-the-money (ATM) put options hold no intrinsic value, as exercising them offers no benefit. Instead, investors might opt to short-sell the stock at the prevailing market price, deeming exercising an OTM put option at an unfavorable strike price unnecessary. However, short selling, especially outside of bear markets, generally entails higher risks than purchasing put options.
Time value, or extrinsic value, is a critical component of an option’s premium. Consider a put option with a strike price of Rs.100, while the underlying stock is trading at Rs.95. This option holds Rs.5 of intrinsic value. However, if the option is priced at Rs.6, the remaining Rs.1 represents time value.
Selling put options involves various considerations. Understanding the value and potential profitability of an option contract is crucial when contemplating a trade, as failure to do so may result in the stock price dropping below the profitable threshold.
Benefits of Put Options
Profit Potential in Different Market Conditions: Put options offer profit potential regardless of market direction. Investors can profit if the asset’s price remains stable or falls. Put option traders can potentially make more money than call option traders.
Advantage of Time Decay: Options are time-bound assets, favoring sellers as expiration approaches. Put option sellers are more likely to profit from time decay. Call option holders aren’t favored by time decay.
Implied Volatility Advantage: Implied volatility affects option prices. Put option traders benefit from selling high implied volatility and buying low. High implied volatility tends to decline over time, benefiting put option buyers in the long run.
Understanding Put Options with Money
Let us understand how Put Options works with an example.
Let’s assume that XYZ company’s stocks are valued at Rs.100. Trader A expects the stock price to go down to Rs.80 in the coming months. This is where the trader buys a put option. There could be three potential scenarios that could be rolled out of this.
| Scenarios | Outcomes |
| The stock price goes up to Rs.120. | If the XYZ company’s stock price goes up to Rs.120 upon expiry, it doesn’t make sense for the Options Buyer to exercise the right and ask the seller to buy it at Rs.100. |
| The stock price goes down to Rs.80. | If XYZ company’s stock price falls down to Rs.80, then the put buyer can demand the seller to buy the stock at Rs.100 from him. This means he can enjoy the profit of Rs.20 from the stock selling. |
| The stock price stays at Rs.100. | If the company’s stock stays flat at Rs.100, the trader won’t exercise the option. As a result, the premium paid would be considered a loss. |
Long Put vs Short Put
Long put is typically buying a put option with the expectation of a decline in the underlying asset’s value. The term “long” denotes the trader’s position of having bought the option, aiming to sell it later at a higher price.
Investors may acquire a long put for speculative purposes, speculating on the underlying asset’s decline to increase the option’s value. Alternatively, it can serve as a hedge against a long position in the underlying asset, where the put option’s value rises as the asset falls, mitigating losses in the underlying investment.
For example, suppose you buy a put option on a stock with a strike price of Rs.100. This entitles you to sell shares of the stock at Rs.100, irrespective of its current market price.
Now, let’s imagine the stock’s market price falls to Rs.80. In this scenario, your put option becomes valuable because you can sell shares at Rs.100, even though the market price is lower, securing a profit of Rs.20 per share (minus the cost of the option). However, if the stock price remains above Rs.100, or even fluctuates around that price, the put option loses its value since it wouldn’t be advantageous to sell shares at Rs.100 when they can be sold for a higher price directly on the market.
If a trader wishes to exercise their right to sell the underlying asset at the predetermined strike price, they can choose to do so. However, it’s worth noting that exercising the option is not mandatory. Alternatively, traders can opt to close their position by selling the put option itself before it expires. This affords traders the flexibility to adapt to changing market conditions and align their investment strategies accordingly.
A short put is an options trading strategy where an investor sells a put option, obligating themselves to buy the underlying asset at a predetermined price (the strike price) if the option is exercised by the option holder. In exchange for selling the put option, the investor receives a premium upfront.
With a short put strategy, you’re solely focused on selling put options. Imagine you’re confident that Company XYZ’s stock won’t dip below Rs.1000. So, you sell a put option for that stock at Rs.1000 and pocket the premium. This premium represents your maximum potential profit from the transaction. However, if the stock price falls below Rs.1000, you’ll end up with losses. Essentially, it’s a gamble on the stock staying above a certain threshold, where you profit from the premium if your prediction holds true, but risk losses if it doesn’t.
When to Buy and Sell a Put Option?
Investors opt for buying put options to amplify potential gains from a stock’s downturn. For a modest initial investment, investors can capitalize on stock prices dipping below the strike price until the option reaches expiration. Purchasing puts is akin to acquiring insurance against a stock’s decline, anticipating a drop in its value before the option matures. In essence, buying puts grants the right (yet not the obligation) to sell the underlying asset at a specified price (the strike) within a set timeframe, with a premium paid for this privilege. Ideally, put buyers hope for the underlying asset’s price to decrease.
Consequently, the holder of a put option realizes profits when the stock’s price falls below the strike price prior to the option’s expiry. Upon exercising the option, the put buyer sells the underlying stock to the put seller at the predetermined strike price. This transaction occurs at a price exceeding the prevailing market rate, resulting in a profit for the buyer.
Imagine XYZ is currently trading at Rs.500 per share. Put options with a strike price of Rs.450 are available for Rs.20 each, expiring in four months. Each put option represents 50 shares of XYZ. Now, let’s say Investor A buys one put option at Rs.20, anticipating a possible decline in XYZ’s stock price.
Investor A expects that the stock price will decrease to Rs.400 by the time the option expires. If the price indeed falls to Rs.400, Investor A can exercise his put option, selling the stock at the strike price of Rs.450 and earning a profit of Rs.50 per share (Rs.450 – Rs.400). His net profit per share would be Rs.30 (Rs.50 – Rs.20, the cost of the put option).
However, if the stock price remains above Rs.450, the put option will expire worthless. In this case, Investor A’s loss would be limited to the premium paid for the put option, which is Rs.20 per share. This illustrates the potential risks and rewards associated with purchasing put options for investors.
Selling a put option can be strategic in various scenarios, depending on an investor’s objectives, market outlook, and risk tolerance.
One situation when selling a put option might be considered is when an investor has a bullish or neutral view on a particular stock or market. In such cases, selling a put option can generate income. The seller receives a premium upfront, providing immediate income regardless of whether the option is exercised or expires worthless.
Another reason to sell put options is for income generation, especially in a sideways or slightly bullish market where significant downward movement in the underlying asset’s price is not expected. The premium received from selling the put option adds to the investor’s income.
Additionally, investors may choose to sell put options if they desire to acquire stock at a lower price. By selling put options with a strike price at or below their desired purchase price, investors can potentially acquire the stock at a lower cost than the current market price if the option is exercised.
Suppose you sell a put option on a stock for a premium of Rs. 50. Later, the stock’s price declines significantly from Rs. 500 to Rs. 300. As the put seller, you now face a net loss. Here’s how the calculation breaks down:
Premium Received: You received Rs. 50 upfront when you sold the put option.
Loss from Purchasing the Stock: Since the stock price fell below the strike price, the option holder may exercise the option, obligating you to buy the stock at the strike price. In this case, you would buy the stock at Rs. 500, even though its market value has dropped to Rs. 300. This results in a loss of Rs. 200 per share.
Putting it together, your net loss would be Rs. 150 per share (Rs. 200 loss from purchasing the stock minus the Rs. 50 premium received earlier).
The Payoff for a Buyer and Seller of a Put Option
The Payoff of an Option Buyer:
On 1st June, the Nifty 50 price is at Rs.22,900. Investor A buys a put option with a strike price of Rs.23,000 at a premium of Rs.150 with an expiry date of 27th June. A put option grants the buyer the right, though not the obligation, to sell the underlying asset at the strike price. In this example, Investor A can sell Nifty at Rs.23,000. The trader will exercise the put option only if the Nifty index drops below the strike price.
For instance, if the Nifty falls below Rs.23,000 at the option’s expiry, Investor A would purchase Nifty from the market at its reduced price and sell it at the strike price. If Nifty stays above Rs.23,000, they will let the option expire. While the maximum loss in the scenario is Rs.150 (Premium paid), the maximum profit could even go to Rs.22,850 (strike price-premium paid) if Nifty’s price falls to 0.
The breakeven point is calculated with the formula (strike price-premium). Here the breakeven point is Rs.23,000 (Strike Price) – Rs.150 (Premium) = Rs.22,850.
The Payoff of an Option Seller:
Put Option Buyer (Long Put)- Maximum Loss = Premium Paid
Put Option Seller (Short Put)- Maximum Profit = Premium Received
The role of an option seller contrasts with that of a put option buyer. While a long put position profits from certain market movements, a short put position incurs losses under the same conditions. If the maximum loss for a long put is limited to the premium paid, then the maximum profit for the short put equals the premium received. Similarly, just as the long put reaches its maximum profit when the price of the underlying asset falls to zero at expiry, the short put position experiences its maximum loss at the same juncture.