If you’ve been keeping up with current trends, you’ve probably noticed that Options Trading is a hot topic these days. And while researching or discussing options trading in the stock market, you may have come across the question, “What is a put option?” Also, how many times have you wondered where you can ‘put’ the put option? If your answers are in the affirmative, then let’s get started without delay.
Content:
- Put Option Meaning
- Put Option Example
- Buy Put Option
- Sell Put Option
- Difference between Call Option and Put Option
- Quick Summary
Put Option Meaning
A put option is a facility that gives the trader the right but not an obligation to sell a security or an asset on or before the expiration of the contract at a fixed price.
The put option depends on the market being bearish. In put option, the investor/buyer is betting on the fact that the stock price will go down. The put option gives buyer the right to sell the stock at a fixed price, regardless of the price of the stock at that point.
Let’s simplify this further…
- Contract buyer is the person willing to pay the premium
- Hence, the person receiving the premium is the contract seller
- Therefore, the premium paid buys the contract buyer the right to sell the stock
- The contract seller now has the obligation to take the premium and buy the stock if the contract buyer feels so.
Put Option Example
Now let’s analyze this example:
Let’s say Tata Steel is at ₹920.
A contract buyer pays a premium of, say, ₹5 and buys the right to sell Tata Steel at ₹920 once the contract expires.
A contract seller takes this premium of ₹5 and agrees to buy Tata Steel at ₹920, no matter what the price of the stock is when the contract expires.
Now, if the stock hits ₹900, the contract seller will have to pay ₹920 to the buyer because he is obligated to do so. The buyer makes a profit.
If the stock hits ₹940, the contract buyer will not sell the stock and prefer to lose the premium of just ₹5 on the transaction.
Buy Put Option
Let’s say you want to buy a put option. When you buy a put option, which is sometimes called a “long put option,” you get the right to sell stock to the person who wrote the put option at a certain price. When you sell a long put option, the person who bought it from you gives you the right to “sell” the underlying asset to the person who bought the put option when the option expires.
Just for clarification, if you buy a put without owning the stock, it is called a long put.
Here is an example for more clarity. Let’s say TCS is trading at ₹850
Contract buyer buys the right to sell TCS to the contract seller at ₹850 on the expiry. The buyer pays a premium to the contract seller to obtain this right.
Now, if on the day of expiry, TCS is at ₹820, then the contract buyer can demand the contract seller to buy TCS at ₹850 from him. This means contract buyers can enjoy the benefit of selling TCS at ₹850 despite it trading at a lower price (₹820) in the open market. If TCS is trading at ₹850 or higher (say ₹870) on expiry, the contract buyer is not obliged to ask the contract seller to buy the shares from him at ₹850 as it makes no profitable sense.
The contract seller will be obligated to buy TCS at ₹850 from the contract buyer because he has sold TCS at ₹850 Put Option to the contract buyer.
Sell Put Option
When an investor sells put option, he/she agrees to buy a stock at a fixed price. Put sellers will lose money if the stock falls. This is so because they must buy the stock at the strike price but can only sell it at a lower price. A put seller will make money if the stock price rises because the buyer won’t exercise the option. The put sellers will take the fee home. The sell put option is also known as the short put option.
Let’s consider a scenario where Mr. Rambo is feeling bullish on a stock when it is at ₹4191.10. He sells Put option with a strike price of ₹4100 at a premium of ₹170.50, expiring after a month.
If the stock price stays above ₹4100, he will gain the amount of premium as the Put buyer won’t exercise his option. In case the stock falls below ₹4100, Put buyer will exercise the option, and Mr. Rambo will start losing money.
If the stock falls below ₹3929.50, which is the breakeven point, Mr. Rambo will lose the premium and more, depending on the extent of the fall in the stock price.
Difference between Call Option and Put Option
Call option gives the trader the right but not an obligation to buy a security or an asset on or before the expiration of the contract at a fixed price.
Put option gives the trader the right but not an obligation to sell a security or an asset on or before the expiration of the contract at a fixed price.
The right to buy is given by a call option, while the right to sell is given by a put option. So, the call operation only makes money when the value of the asset it is based on is going up. On the other hand, a person who buys a put option will only make money if the value of the underlying asset goes down.
Quick Summary
So, here are some points to remember.
- Put option gives the right but not the obligation to sell a security on expiry at a fixed price.
- Premium paid buys the contract buyer the right to sell the stock.
- A buy put option is profitable when the market is bearish, i.e., when the value of the stock declines.
- A sell put option is profitable when the market is bullish, i.e., when the value of the stock doesn’t go down.
