Introduction to Put Options
An option that conveys the right to sell something is called a Put option. It gives the option to sell a stock at a predetermined price.
The put option buyer is betting on the fact that the stock price will go down and in order to profit from this view he enters into a Put Option agreement. In a put option agreement, the buyer of the put option can buy the right to sell a stock at a particular price irrespective of where the underlying/stock is trading at.
In markets, whatever the buyer of the option anticipates, the seller anticipates the exact opposite, and that’s how an efficient market exists.
So if the Put option buyer expects the market to go down by expiry, then the put option seller would expect the market to go up or stay flat.
A put option buyer buys the right to sell the underlying to the put option writer at a predetermined rate.
Assume Reliance Industries is trading at ₹1850/-
A put option buyer buys the right to sell Reliance to put option seller at ₹1850/- upon expiry. To obtain this right, put option buyer has to pay a premium to the put option seller. Against this premium put option seller will agree to buy Reliance, if the contract is exercised.
On expiry Reliance is at ₹1820/- then the option is exercised , so buyer of put option can demand the option seller to buy Reliance at ₹1850/- from him.
This means put option buyer can enjoy the benefit of selling Reliance at ₹1850/- when it is trading at a lower price in the open market (₹1820/-). Put option seller will be obligated to buy Reliance at ₹1850/-
If Reliance is trading at ₹1850/- or higher upon expiry (say ₹1870/-) it does not make sense for put option buyer to exercise his right and sell the shares at ₹1850/-. This is quite obvious since he can sell it at a higher rate in the open market.
An agreement where one obtains the right to sell the underlying asset at a pre-determined price on expiry is called a ‘Put option’
So three takeaway points from this example is:-
1. The buyer of the put option is bearish about the underlying asset, while the seller of the put option is neutral or bullish on the same underlying asset.
2. The buyer of the put option has the right to sell the underlying asset upon expiry at the strike price.
3. The seller of the put option is obligated (since he receives an upfront premium) to buy the underlying asset at the strike price from the put option buyer if the buyer wishes to exercise his right.
A long put, means buying a put option. It is a Bearish Strategy.
When to use: When we expect the spot price to be less than the strike price, and we are bearish on the market direction.
Maximum Loss: Limited to the extent of premium paid which will arise only when Spot Price > Strike Price.
Maximum Profit: It is theoretically Unlimited as the market falls and arises when Spot Price < Strike Price
The payoff from a long position in a put option can be given by the equation
= Max (E – S, 0) - P
E = Strike price
S = Price of the underlying security at maturity
P = Put option premium
The payoff from a short put position is exactly opposite of from long put. It is a bullish strategy and the payoff can be given by
= Min (E – S, 0) + P
We can Sum up Call and Put pay off by the following Table:
To clearly tabulate when a call and a put option is exercised or lapse, we have: