- A put option is a contract that gives the buyer the right, but no obligation to sell the underlying asset at a specific price also known as the strike price.
- Put buying is one of the simplest ways for trading put options.
- Put sellers sell options with the expectation to lose value for benefiting from the premiums received for the option.
- A put option can be used for speculation, income generation, and tax management
We hope that by now you are familiar with the Basics of Call Option from both the buyers as well as the seller’s perspective.
A call option is an option contract in which the buyer has the right to buy a specified quantity of the underlying stock at a predetermined price without any obligation.
|Table of Contents|
|What is a Put Option?|
|What it means by Buying Put Options?|
|What it means by Selling Put Options?|
|Put Option Formula|
|Put Option Premium|
|Put Option Trading|
If you are now familiar with the call option then understanding ‘Put Options’ is quite easy.
The view on put option from the buyer’s perspective is that the markets should be bearish as opposite to the bullish view of a call option buyer.
Let us discuss the basics of the put option and then we will drive the put option premium and trading:
What is a Put Option?
A put option is an option contract that gives the buyer the right, but no obligation to sell the underlying asset at a specific price also known as the strike price.
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They help us to protect our trades against the decline in the price of the above assets below a specific price.
Each put contract comprises 100 shares of the underlying security.
The trader does not have to own the underlying asset for purchasing or selling puts.
The put buyer has the right, but not the obligation, for selling the asset at a particular price, within a specified period.
Whereas, the seller has the obligation to buy the asset at the strike price if the option owner exercises their put option.
What it means by Buying Put Options?
Put buying is one of the simplest ways for trading put options.
When the options trader has a bearish view of a particular stock, then he can purchase put options to profit from a decline in the asset price.
The price of the asset must move below the strike price of the put options before the expiration date for this strategy in order to earn profits.
Suppose the stock is trading at Rs.4900 and put option contract with a strike price of Rs.70 expiring in a month’s time.
You are expecting that the price of the stock will drop sharply in the coming weeks after their earnings report.
The payoff diagram of the examples will look as below:
If the prices fall as expected then we can earn unlimited profits.
But if our trade does not go according to our expectations, then our loss will be only limited to the premium price that we had paid.
You can practice long put options strategies using Elearnoptions.
What it means by Selling Put Options?
Put sellers sell options with the expectation to lose value for benefiting from the premiums received for the option.
Once puts have been sold to a buyer, then the seller has the obligation to buy the underlying asset at the strike price if the option is exercised.
The stock price must increase above the strike in order to make a profit.
If the underlying stock’s price falls below the strike price before the expiration date, then the buyer makes a profit on the sale.
The buyer has the right to sell the puts, while the seller has the obligation and buy the puts at the specified strike price.
However, if the puts above the strike price, the buyer stands to make a loss.
From the above diagram we can that the profit is limited to the premium whereas if the prices move against our expectation then we may suffer unlimited losses.
Put Option Formula:
If you want to calculate the value of the put option, then we will need 2 parameters:
• The exercise price
• The current market price of the underlying asset
If the option is exercised, then we can find out the value of the put option, by the below formula:
Value= Exercise Price-Market Price of the Underlying Asset
If the option is not exercised, then it has no value.
Put Option Premium:
For calculating the put option premium, you will need:
• Intrinsic Value
• Time Value
To calculate the intrinsic value, you require the current market price of the underlying stock and the strike price.
The difference between these two is known as the intrinsic price.
The time value depends on how far is the expiration date from the current date. Also, the higher the volatility, the higher is the time value.
Put Option Trading:
A put option can be used for speculation, income generation, and tax management:
Put options are extensively used by the trader when then expect fall in the prices of the underlying stock
2. Income generation:
Traders can just sell the put option on shares instead of holding the securities.
3. Tax management:
Traders can eliminate paying huge taxes on the capital gain on the stocks by just paying the taxes on the put option.
You can also use option scans to filter out stocks for trading the next day by using the StockEdge web version.