Chapter 2.7: Understanding How Put Options Work
In the previous section, we learnt about ‘call’ options, which are contracts that enable you to buy at a fixed price in the future. In this part, we will learn about ‘put’ options.
What are Put Options:
In any market, there cannot be a buyer without there being a seller. Similarly, in the Options market, you cannot have call options without having put options. Puts are options contracts that give you the right to sell the underlying stock or index at a pre-determined price on or before a specified expiry date in the future.
In this way, a put option is exactly opposite of a call option. However, they still share some similar traits.
For example, just as in the case of a call option, the put option’s strike price and expiry date are predetermined by the stock exchange.
Here are some key features of the put option:
Here are some key features of the call option:
- Specifics: To buy a ‘call’ option, you have to place a buy order with your broker specifying the strike price and the expiry date. You will also have to specify how much you are ready to pay for the call option.
- Fixed Price: The strike price for a call option is the fixed amount at which you agree to buy the underlying assets in the future. It is also known as the exercise price.
- Option Premium: When you buy the call option, you must pay the option writer a premium. This is first paid to the exchange, which then passes it on to the option seller.
- Margins: You sell call options by paying an initial margin, and not the entire sum. However, once you have paid the margin, you also have to maintain a minimum amount in your trading account or with your broker.
- Premium: Stock and Index Options: Depending on the underlying asset, there are two kinds of call options – Index options and Stock options. Option can only be exercised on the expiry date. While most of the traits are similar .
- Seller’s Premium: You can also sell off the call option to another buyer before the expiry date. When you do this, you receive a premium . This often has a bearing on your net profits and losses.
When do you buy a Put Option:
There is a major difference between a call and a put option – when you buy the two options. The simple rule to maximize profits is that you buy at lows and sell at highs. A put option helps you fix the selling price. This indicates you are expecting a possible decline in the price of the underlying assets. So, you would rather protect yourself by paying a small premium than make losses.
This is exactly the opposite for call options – which are bought in anticipation of a rise in stock markets. Thus, put options are used when market conditions are bearish. They thus protect you against the decline of the price of a stock below a specified price.
Kinds of put options:
There are two kinds of put options – American and European – on the basis of when an option can be exercised. American options are more flexible; they allow you to settle the trade before the expiry date of the contract. European options can only be exercised on the day of the expiry. Thus, index options are European options, while stock options are a kind of American options.
Illustration of a Put Index Option
Suppose the Nifty is currently trading at 6,000 levels. You feel bearish about the market and expect the Nifty to fall to around 5,900 levels within a month. To make the most of your view of the market, you could purchase a 1-month put option with a strike price of 5900. If the premium for this contract is Rs 10 per unit, you will have to pay up Rs 1,000 for the Nifty put option (100 units x Rs 10 per unit).
So, if the index remains above your strike price of 5,900, you would not really benefit from selling at a lower level. For this reason, you would chose to not exercise your option. You just lose your premium of Rs 1,000.
However, if the index falls below 5,900 levels as expected to say 5,850 levels, you are in a position to make profits from your options contract. You will thus choose to exercise your option and sell the index. That said, remember to take into consideration your premium costs. You will need to recover that cost too. For this reason, you will start making profits only once the index level falls below 5,890 levels.
Illustration of a Put Stock Option:
Put options on stocks also work the same way as call options on stocks. However, in this case, the option buyer is bearish about the price of a stock and hopes to profit from a fall in its price.
Suppose you hold ABC shares, and you expect that its quarterly results are likely to underperform analyst forecasts. This could lead to a fall in the share prices from the current Rs 950 per share.
To make the most of a fall in the price, you could buy a put option on ABC at the strike price of Rs 930 at a market-determined premium of say Rs 10 per share. Suppose the contract lot is 600 shares. This means, you have to pay a premium of Rs 6,000 (600 shares x Rs 10 per share) to purchase one put option on ABC.
Remember, stock options can be exercised before the expiry date. So you need to monitor the stock movement carefully. It could happen that the stock does fall, but gains back right before expiry. This would mean you lost the opportunity to make profits.
Suppose the stock falls to Rs 930, you could think of exercising the put option. However, this does not cover your premium of Rs 10/share. For this reason, you could wait until the share price falls to at least Rs 920. If there is an indication that the share could fall further to Rs 910 or 900 levels, wait until it does so. If not, jump at the opportunity and exercise the option right away. You would thus earn a profit of Rs 10 per share once you have deducted the premium costs.
However, if the stock price actually rises and not falls as you had expected, you can ignore the option. You loss would be limited to Rs 10 per share or Rs 6,000.
Illustration of Put stock option
Thus, the maximum loss an investor faces is the premium amount. The maximum profit is the share price minus the premium. This is because, shares, like indexes, cannot have negative values. They can be value at 0 at worst.
What are the payments and margins involved in buying and selling Put Options:
Whether you are a buyer or a seller, you have to pay an initial margin as well as an exposure margin. In addition to these two, additional margins are collected. These differ for buyers and sellers, who are at the opposite ends of the spectrum.
Here’s a look:
How to settle a Put Option:
There are three common ways to settle put options contracts.
Types of margin payments
For put index options, you cannot physically settle, as the index is not tangible. So, to settle index options, you can either exit your position through an offsetting trade in the market. You can also hold your position open until the option expires. Subsequently, the clearing house settles the trade.
Now let’s see how this differs if you are a buyer or writer put options:
In this section, we understood the basics of Options contracts. In the next part, we go into details about Call options and Put options. Click here