Put Options: Learn the Basics of Buying and Selling

Investors rely on put options as a significant hedging tool to manage and use the strengths of market movements that favour their investment positions. The core knowledge of put options is quintessential for anyone who is entering the derivatives market. In this article, we are going to look deeper into the fundamental aspect of put options, how they work, the returns they offer, and the strategies that you may devise. Whether it is just the beginning of your investing journey or you have been in the game for a while, a thorough understanding of these concepts will take you a long way. 

What are Put Options?

Put options are financial contracts that give the holder the right, but not the obligation, to sell a specific asset (such as stocks, commodities, or currencies) at a previously determined price (known as the strike price) within a specified period of time (until the expiration date).

Thus, a put option provides its holder with a form of insurance against the decline in the value of the underlying asset. If the price of the asset decreases below the strike price, the holder can exercise the option to sell the asset at the higher strike price, thereby limiting their potential losses.

These are commonly used by investors to hedge against downside risk in their investment portfolios or to speculate on the price decline of an asset. They play a vital role in options trading and are a fundamental tool for managing risk and capitalising on market movements.

To illustrate how put options work in real-life scenarios, let's consider a hypothetical situation:

Imagine you're an investor holding 100 shares of Company XYZ, which are currently priced at ₹3,000 per share in the Indian stock market. However, you have concerns that the stock's value might decline in the coming weeks due to economic uncertainties.

To safeguard your investment against potential losses, you decide to purchase a put option on Company XYZ with a strike price of ₹2,800 and an expiration date one month from now. This means you have the right (but not the obligation) to sell your shares at ₹2,800 each, regardless of their market value at the time of expiration.

Now, let's explore two possible outcomes:

If the stock price of Company XYZ falls below ₹2,800 before the expiration date, your put option becomes valuable. For instance, if the stock price drops to ₹2,600 per share, you can exercise your put option and sell your shares at the agreed-upon price of ₹2,800 each, thus minimising your losses.

Conversely, if the stock price of Company XYZ remains above ₹2,800 or rises further, your put option may expire worthless. In this scenario, you're not obligated to sell your shares at the strike price, but you've paid a premium for the option contract, resulting in a loss on your investment.

This example demonstrates how put options can act as a form of insurance for investors in the Indian stock market, allowing them to protect their investments against potential downside risks. 

Buyer of a Put Option

The buyer and the seller are the two primary players when it comes to put options. It is important to understand each of their roles to decipher how put options work. Let's start by examining the role of the buyer.

The buyer of a put option, also known as the holder, pays a premium to acquire the right to sell the underlying asset at the predetermined strike price within a specified timeframe. This right allows the buyer to protect their investment or profit from a decline in the price of the underlying asset.

Buyers of put options typically have one of two motivations:

• Hedging: Investors may purchase put options as a form of insurance to hedge against potential losses in their investment portfolio. By owning put options on assets they already hold, investors can limit their downside risk if the market moves against them.
• Speculation: Some investors buy put options with the expectation that the price of the underlying asset will decrease before the option's expiration date. If their prediction is correct, they can profit by selling the asset at the higher strike price specified in the put option contract.

For the buyer of a put option, the maximum potential loss is limited to the premium paid for the option contract. However, the potential profit is theoretically unlimited if the price of the underlying asset declines significantly below the strike price.

Payoff for a Buyer of a Put Option

Let's explore how the payoff for a buyer of a put option varies depending on the price of the underlying asset at expiration:

• In-the-Money (ITM) Put Option: If the price of the underlying asset at expiration is below the strike price of the put option, the option is considered in-the-money (ITM). In this scenario, the buyer of the put option can exercise their right to sell the asset at the higher strike price, even though its market value is lower. The payoff for the buyer is calculated as the difference between the strike price and the market price of the asset at expiration, minus the premium paid for the option contract.
• Payoff = Max(0, Strike Price - Asset Price at Expiration) - Premium Paid

For Example: You purchase a put option on Company XYZ with a strike price of ₹100 and pay a premium of ₹5.

• At expiration, the price of Company XYZ stock is ₹90.
• Payoff = Max(0, ₹100 - ₹90) - ₹5 = ₹10 - ₹5 = ₹5

In this scenario, the put option is in-the-money because the stock price is below the strike price. The payoff for the buyer is ₹5.

• At-the-Money (ATM) Put Option: If the price of the underlying asset at expiration is equal to the strike price of the put option, the option is considered at-the-money (ATM). In this case, the put option has no intrinsic value, as there is no profit to be gained from exercising the option. The payoff for the buyer is equal to the negative of the premium paid for the option contract.

• Payoff = - Premium Paid

• Let's use the same example as above, but this time the stock price at expiration is ₹100.
• Payoff = - ₹5

Here, the put option is at-the-money because the stock price is equal to the strike price. The buyer's payoff is just the negative of the premium paid, which is ₹5.

• Out-of-the-Money (OTM) Put Option: If the price of the underlying asset at expiration is above the strike price of the put option, the option is considered out-of-the-money (OTM). In this situation, the buyer of the put option has no incentive to exercise their right to sell the asset at a lower price than its market value. The payoff for the buyer is equal to the negative of the premium paid for the option contract.

• Payoff = - Premium Paid

• Continuing with the previous example, let's say the stock price at expiration is ₹110.
• Payoff = - ₹5

In this case, the put option is out-of-the-money because the stock price is above the strike price. The buyer's payoff remains the negative of the premium paid, which is ₹5.

The payoff for a buyer of a put option, thus, depends on whether the option is ITM, ATM, or OTM at expiration. 

Seller of Put Options

The seller, also known as the writer is another key player here, is the individual or entity who grants the buyer the right to sell the underlying asset at the predetermined strike price within a specified period.

Sellers of put options typically have one of two motivations:

• Income Generation: Sellers collect premiums from buyers in exchange for assuming the obligation to buy the underlying asset at the strike price if the buyer chooses to exercise the option. This premium serves as income for the seller, especially if the option expires worthless.
• Bullish Outlook: In some cases, sellers may be bullish on the underlying asset and willing to acquire it at a potentially lower price. Selling put options allows them to potentially purchase the asset at a discount if the option is exercised.

For the seller of a put option, the maximum profit is limited to the premium received from selling the option contract. However, the potential loss can be significant if the price of the underlying asset decreases substantially below the strike price, as the seller may be obligated to buy the asset at a higher price than its market value.

Payoff for a Seller of a Put Option

Understanding the potential payoff for a seller of a put option is crucial for evaluating the profitability and risk associated with this strategy. Let's explore how the payoff for a seller of a put option varies depending on the price of the underlying asset at expiration:

• In-the-Money (ITM) Put Option: If the price of the underlying asset at expiration is below the strike price of the put option, the option is considered in-the-money (ITM). In this scenario, the seller of the put option may be obligated to buy the asset at the higher strike price, even though its market value is lower. The payoff for the seller is calculated as the difference between the strike price and the market price of the asset at expiration, plus the premium received for selling the option contract.
• Payoff = Strike Price - Asset Price at Expiration + Premium Received
• Suppose a seller writes a put option on Company ABC with a strike price of ₹100 and receives a premium of ₹5.
• At expiration, the price of Company ABC stock is ₹90.
• Payoff = ₹100 - ₹90 + ₹5 = ₹15

In this scenario, the put option is in-the-money because the stock price is below the strike price. The payoff for the seller is ₹15.

• At-the-Money (ATM) Put Option: If the price of the underlying asset at expiration is equal to the strike price of the put option, the option is considered at-the-money (ATM). In this case, the put option has no intrinsic value, as there is no profit to be gained from exercising the option. The payoff for the seller is equal to the premium received for selling the option contract.

• Payoff = Premium Received

• Let's use the same example as above, but this time the stock price at expiration is ₹100.
• Payoff = ₹5

Here, the put option is at-the-money because the stock price is equal to the strike price. The seller's payoff is just the premium received, which is ₹5.

• Out-of-the-Money (OTM) Put Option: If the price of the underlying asset at expiration is above the strike price of the put option, the option is considered out-of-the-money (OTM). In this situation, the seller of the put option has no obligation to buy the asset at a lower price than its market value. The payoff for the seller is equal to the premium received for selling the option contract.

• Payoff = Premium Received

• Continuing with the previous example, let's say the stock price at expiration is ₹110.
• Payoff = ₹5

In this case, the put option is out-of-the-money because the stock price is above the strike price. The seller's payoff remains the premium received, which is ₹5.

By understanding the potential payoff under different scenarios, sellers can assess the risk and reward of selling put option. This will enable them to make informed decisions based on their investment objectives and market outlook.

Final Word

Put options are a key financial tool for risk management, market speculation, and strategy enhancement. They allow investors to hedge against potential losses, profit from price declines, or use market volatility to their advantage. Understanding put options' basics, such as their operation, payoff structures, and key concepts like in-the-money and out-of-the-money options, is crucial for effective trading. 

This brings us to the end of this chapter and we will explore put option strategies in the next chapter.