What is a Put Option?
A put option (PE) is a derivative contract that gives the buyer the right but not the obligation to sell the underlying asset on a specific date at a predetermined price. Traders can use this option on multiple securities, including stocks, commodities, currencies, and indices. In India, all options are exercised as European options. A Put Option is denoted as PE.
The price at which one can buy or sell a put option is called the premium. The premium or value of put option fluctuates based on the price of the underlying asset, the predetermined price (strike price) of the option, time, interest rates, and volatility.
The premium of put option goes up when the price of the underlying asset goes down. Alternatively, the premium of this option goes down when the price of the underlying asset goes up.
The buyer pays a premium to earn the right to exercise the option, whereas the seller of the put option receives a premium.
A buyer of the put option is bearish about the market and also expects the price of the underlying security to fall in the future. The buyer can also be betting that the price of the security will go down. On the other hand, the seller of the put option wants to earn immediate income in the form of a premium and is betting that the price will either increase or stay the same.
How Does a Put Option Work?
Put options are used by investors to hedge the downside risk or to speculate when the price of the asset is expected to go down. Either way, if the price of the asset goes down, the buyer of the put option will benefit, and also the seller will be at a loss. On the other hand, if the asset price goes up or stays the same, the buyer of the put option will lose the premium amount, and the seller will profit.
When an investor buys a put option, he has a right to sell the shares. However, he will only exercise it if the asset’s price at expiry (spot price) is below the contract’s predetermined price (strike price). This is also called in-the-money option. In this case, the buyer of the option is earning a profit, given that the premium paid is lower than the difference in spot and strike.
The option is out of money when the spot price is above the strike price of the contract. In this case, the investor will not exercise the contract as he can earn more by selling the shares at the current price than the price he fixed (strike price) in the contract. Since he is not exercising the contract, the investor loses the premium amount, and the put option becomes worthless.
The option is at the money when the spot price is the same as the strike price. In this case, the investor will earn the same profit by exercising or not exercising the contract.
Buying a Put Option
A put option can be used to hedge the downside risk of investing, or it can be used to speculate. Hence it is not important to hold the security to purchase a put option.
If the put option is used for hedging, then the buyer of the put will also hold the underlying security. In this case, if the price of the security goes down, the buyer can exercise the right to sell and sell the security at the strike price.
Alternatively, if the put is used for speculating, then the buyer of the PE will buy the contract without holding the security. In this case, the buyer of the put option is betting that the price of the security will go down. If the underlying security’s price goes down upon expiry (spot price), then the put option’s premium will go up. The buyer can then sell the contract before expiry and benefit from the difference in premium.
Suppose the price of the security stays the same or goes up during the contract period, the buyer will not exercise the right and will lose the premium paid.
The profits for the buyer of the PE are unlimited, whereas the loss is limited to the premium paid.
Let’s understand with an example how a buyer of the put option benefits from a fall in the security’s price and loses when the price goes up.
If the shares of Company X are currently trading at Rs 30, Mr Akash expects it to fall below Rs 25 after a month. He buys a put option with a strike price of Rs 25 at a premium of Rs 1 per share. A contract has 100 shares. Let’s see the profit or loss Mr Akash makes if the shares fall below 25, go up to 35 or are in the same range of Rs 30.
|Price upon expiry||Profit from the put option (Strike – Spot – Premium paid) * number of shares|
From the above table, it is clear that Mr Akash is at a profit when the price of the share is falling. His profits are unlimited, whereas his loss is limited to the premium he paid, as he won’t choose to exercise the contract if the price of the security stays in the same range or goes up.
Executing a Put Option
By exercising a put option, the buyer of the put option will sell the underlying shares and also make a profit. Suppose the buyer of the put option exercises the right before expiry, then he will benefit from the difference in premium amount. On the other hand, the seller will be at a loss and will be forced to buy the shares at a higher price than the market price.
Exiting a Put Option
Ideally, a buyer of the PE can choose to exit the option when they are no longer bearish about the underlying security.
Selling a Put Option
The seller of the PE has an obligation to buy the security at the predetermined price if the buyer exercises the right upon the expiry of the contract. The seller is under obligation because he has already pocketed the premium amount paid by the buyer.
If a person sells the PE, they are speculating that the price of the security will remain the same or will go up in the future. Alternatively, a person also sells the put option if they want to buy the security in the future and expects the price to go up.
If the price upon expiry (spot price) remains above the strike price, then the seller of the put will benefit from the premium received. However, if the spot price goes below the strike price, then the seller of the PE will have unlimited losses.
Let’s understand with an example how the seller of the PE benefits from the rise in the price of the security and losses when the price goes down.
In the above example, if Mr Akash expects the price to stay above Rs 25 and sells a put option of the strike price of Rs 25 for Rs 1 per share. Let’s see the profit or loss Mr Akash makes if the shares stay above Rs 25 or go below Rs 20.
|Price upon expiry||Profit from the put option (Spot – Strike + Premium Received) * number of shares|
From the above table, it is clear that Mr Akash is profitable when the price is Rs 25 and above. If the shares fall before Rs 25, then he is at a loss. The profits are limited to the premium received, while the losses are unlimited.
Advantages and Disadvantages of a Put Option
Advantages of put options
- A buyer of the PE can make unlimited profits when the price of the security falls.
- Buying a put option when holding the security is like buying insurance for your investment.
- A seller of the PE can earn immediate income in the form of a premium.
- If the security price goes above the strike price upon expiry, then the seller will benefit from the premium received.
- If used properly, a combination of buying and selling PE can give good profits.
Disadvantages of put options
- If the price of the security goes up, the buyer of the PE loses the entire investment amount, in this case, the premium paid.
- A seller of the PE will face unlimited losses if the price of the security falls below the strike price upon expiry.
- The profits of a seller of the PE are also limited to the premium received.
- Trading in these options can be very risky, and it also requires knowledge about the market.
Difference Between Put Option and Short Selling
Buying a put option and short selling are bearish strategies. But they are quite different. The maximum loss of a buyer of a put option is limited to the premium paid, whereas short selling has unlimited risk as losses are unlimited.
Frequently Asked Questions
If you don’t sell your put option or square off your position on the day of expiry, the stock exchange will automatically square off the position for you. Also, if you are supposed to deliver your shares, and you don’t, the exchange will auction them off in the market at the market price.
Most of the time, options are not exercised but sold off to make profits. Also, options are speculative contracts, and it makes sense to make quick profits from them by selling them. However, if you intend to hold the underlying asset, then it is better to exercise the option.
If you are bearish about the market, then buying a PE will help you make unlimited profits if the market goes down. On the other hand, selling a PE will be profitable if you are bullish about the market and want to make immediate money.
No, the put option can be exercised only at the time of expiry in India.
In-the-money put is when the spot price is less than the strike price. While Out of the money put is when the spot price is higher than the strike price.
Yes, you can lose the entire premium you paid for buying the PE if the spot price is higher than the strike price on expiry.