In the world of investing, put options can be an extremely powerful tool—whether you want to protect your investments or profit from a falling market.
If you’re new to investing or unfamiliar with the concept of options, don’t worry! This guide will break down everything you need to know about put options in a detailed yet simple way, using easy-to-understand language.
We will also use relevant examples to help clarify key points.
What Is a Put Option?
A put option is a financial contract that gives the buyer the right (but not the obligation) to sell a specific asset—such as a stock—at a predetermined price, known as the strike price, within a set period of time before the option expires.
Put options are used to make profits when the price of an asset falls. They also allow investors to protect their investments from falling prices by locking in a sell price.
How Do Put Options Work?
Think of a put option as a type of “insurance” for an asset you own or a tool to profit from a market downturn.
Here’s how it works:
Imagine you are interested in buying a put option on a stock:
- Stock price (current): ₹3,200
- Strike price: ₹3,300
- Premium: ₹150
- Expiration date: 6 months
Let’s break this down:
Stock Price Goes Up (₹3,500)
If the stock price increases, you don’t need to use the put option because you can sell the stock in the market for a higher price (₹3,500) than the strike price (₹3,300).
In this case, the put option expires worthless, and you lose the ₹150 premium you paid to purchase the option.
Stock Price Goes Down (₹2,800)
If the stock price decreases to ₹2,800, your put option becomes valuable. You can sell the stock at ₹3,300 (strike price), even though the market price is only ₹2,800. This means you’re profiting by selling the stock for a higher price than what it’s currently worth in the market.
Your total profit is ₹500 per share (₹3,300 – ₹2,800), minus the ₹150 premium you paid for the option, leaving you with a net profit of ₹350.
Stock Price Stays the Same (₹3,300)
If the stock price stays at ₹3,300, it is the same as the strike price. Since there is no advantage to exercising the option (you can sell it for the same price in the market), the put option expires worthless, and you lose the ₹150 premium you paid.
Why Do Investors Buy Put Options?
There are two main reasons investors use put options: speculation and hedging.
Speculating with Put Options
Speculation is when you bet on the price of an asset to fall. If you expect a stock to decrease in price, you can buy a put option to profit from that decline. Here’s how:
- If you think a stock currently trading at ₹100 will fall to ₹80, you might buy a put option with a strike price of ₹90 for a premium of ₹10.
- If the stock price drops below ₹90, you can exercise the option to sell the stock at ₹90, making a profit.
In this case, your profit comes from selling at a higher price than the market value.
Hedging with Put Options
Hedging is about protecting your investments from loss. If you own shares of a stock and are concerned that the price might fall, you can buy a put option to limit your potential losses. Here’s an example:
- Let’s say you own 100 shares of a company, and its current price is ₹1,000 per share. You worry that the stock might drop to ₹800, but you don’t want to sell your shares yet.
- You can buy a put option with a strike price of ₹900. If the stock price falls below ₹900, the put option gives you the right to sell at ₹900, limiting your loss even though the stock price dropped.
So, the put option acts like insurance, allowing you to protect the value of your investments.
American vs. European Put Options
Put options come in two main types: American and European. The key difference is when you can exercise the option.
American Put Options
- You can exercise an American put option at any time before or on the expiration date.
- This flexibility can be useful if the stock price suddenly falls significantly.
- Example: You buy an American put option for XYZ Industries stock, with a strike price of ₹2,400. The stock falls to ₹2,200 within the first week, and you can exercise the option early, selling at ₹2,400.
European Put Options
- A European put option, on the other hand, can only be exercised on the expiration date—not before.
- Even if the stock price falls dramatically before the expiration date, you have to wait until the expiration date to sell.
- Example: You buy a European put option for ABC Motors with a strike price of ₹500. The stock falls to ₹470 just before expiration, and you can sell at ₹500 only on the expiration date.
In India, European-style options are used, while in the US market, American-style options are more common.
Important Terms to Know in Put Options
To fully understand how put options work, you need to be familiar with some key terms:
- Strike Price: The price at which you can sell the asset under the terms of the option contract. If the stock price falls below the strike price, the put option becomes valuable.
- Premium: The cost you pay to buy the put option. It’s similar to paying for insurance. The premium is non-refundable, even if the stock price doesn’t fall as expected.
- Expiration Date: The last date on which you can exercise the put option. After this date, the option expires, and you lose the premium you paid.
Buyer vs. Seller of Put Options
There are two main parties involved in every put option: the buyer and the seller (also known as the put writer).
Buyer of a Put Option
- Goal: The buyer of a put option is betting that the price of the asset will fall. If the price falls below the strike price, they can sell at a higher price.
- Maximum Loss: The buyer’s maximum loss is the premium paid for the option. For example, if the premium is ₹150, that’s the most the buyer can lose.
- Maximum Gain: The maximum gain is theoretically unlimited if the price falls sharply. For instance, if the stock price falls to zero, the buyer profits by selling at the strike price.
Seller of a Put Option (Put Writer)
- Goal: The seller is betting that the price of the asset will stay above the strike price. If the stock price does not fall, the seller keeps the premium received for selling the option.
- Maximum Gain: The maximum gain for the seller is the premium received for selling the option. In the example above, this would be ₹150.
- Risk: The seller faces significant risks if the price falls below the strike price. They may have to buy the asset at a higher price than its current market value, leading to potential losses.
Put Option Payoff Structure
Here’s how the payoff works for both buyers and sellers of put options:
Buyer’s Payoff
- If the price falls below the strike price: The buyer can sell at the higher strike price, making a profit.
- If the price stays above the strike price: The option expires worthless, and the buyer loses only the premium paid.
Seller’s Payoff
- If the price stays above the strike price: The seller keeps the premium received for selling the option, and the option expires worthless.
- If the price falls below the strike price: The seller may have to buy the asset at the strike price, which can lead to significant losses.
Put Options vs. Call Options
Put options and call options are two different types of options contracts:
- Call Options: Give the holder the right to buy an asset at a set price if they believe the price will rise.
- Put Options: Give the holder the right to sell an asset at a set price if they believe the price will fall.
By understanding how put options work, the risks involved, and the different strategies for using them, you can make more informed investment decisions and take advantage of price movements in the market—whether it’s rising or falling.
Conclusion: Why Use Put Options?
Put options are versatile tools that can assist investors in two primary ways: hedging against market downturns by protecting their portfolio from falling prices through a locked-in selling price, and speculating on price declines by profiting from a market downturn, betting that the asset’s price will fall.
