A put option primer

Put options are derivatives that give you the right, but not the obligation, to sell an asset at a predetermined date at a specific price. These are used for many kinds of assets, including stocks, commodities, minerals, energy products like petroleum, and so on.

These derivatives were introduced in the Indian stock markets in 2001. Today, the Securities & Exchange Board of India (SEBI) offers futures and options on 175 specified securities.

Put option explained

Let’s take an in-depth look at what is a put option in share market. You should buy it when you expect prices to fall, in this way you may make profits. In the case of call options, the opposite takes place. People buy call options when they expect prices to rise.

To understand put option meaning better, let’s use an example. Let’s suppose you expect the share price of company XS to fall short. So you buy options of company XS at the rate of Rs 50 each, giving you the right to sell them at that price on the expiry date. If the price of the XS share falls to Rs 40, you can choose to exercise your trade at the strike price of Rs 50, thereby making a profit of Rs 10 for each. If you had purchased 1,000 options, you would have earned Rs 10,000 on the transactions.

Let’s see what happens when the price of XS shares goes up to Rs 60. In this case, if you exercised your put at Rs 50, you will stand to lose Rs 10, or Rs 10,000 if you purchased 1,000 options. You would not want to enter into such a loss-making transaction. So you have the choice of not exercising the right to sell. In this case, the only loss would have been the premium that you have paid to enter into the transaction. This will generally be much lower than your losses, depending on the size of the deal.

You can also buy these for indices like the Sensex and the Nifty. It works the same way as a stock option. Suppose you expect the Nifty 50 index to fall. You then purchase 100 of Nifty. If the Nifty falls from the current 11,900 to 11,400, you can exercise the option and book profits, which will be (11,900-11,400) x 100, or Rs 50,000.

A put can be used to hedge against any price changes in the stocks you already hold in your portfolio. Let’s suppose you own 1,000 shares of company XS, whose prices you expect to fall shortly from the prevailing Rs 50. You don’t want to sell those shares right now, but still, want to hedge against a fall in price. So you buy 1,000 of company XS at the rate of Rs 50 each. If the price of your shares falls to Rs 40, you will be able to sell the options at the strike price of Rs 50 at the end of the expiry period. This means you would make a profit of Rs 10,000, which can be used to offset any losses in your portfolio. This is known as a `protective’ put strategy.

Leveraging in put options

One of the main attractions of trading in options is the chance of leveraging. This is because you can get options contracts at a fraction of the price of the underlying. You only have to pay the premium to enter into an options contract, which will be much lower than the cost of the underlying. The higher exposure means more opportunities for profit. And unlike futures, where you have no choice but to go through with the contract, in options you have the choice of not exercising it. The only downside if you don’t exercise your right is the premium paid to buy the put option.

What is premium?

When you are trying to understand what is put option in share market, you must also have a good grasp of the premium you have to pay when you enter into an options contract. When you buy put option, the premium has to be paid to the broker, which is then transferred to the exchange, and thereupon to those that sell put option. So the premium is the cost for the buyer, and income for the seller, or option writer.

The premium calculated is determined by various factors, like the current price of the underlying asset, the difference between the market price and the strike price (the price at which the options contract is exercised), and the time till the date of expiry of the contract.

Premium is not a static thing but is dependent on changes in the price of the underlying. In the case of a put, the premium decreases as the price of the underlying (stocks or indices) increase. This is the opposite in the case of a call option. Here, the premium increases as the price of the underlying go up.

An option’s premium increases when it goes more into in-the-money, which in the case of a put is when the strike price is above the market price of the underlying. In this situation, the options contract is worth exercising since the price of the stock/ index is below the strike price.

Conversely, premiums will fall when the put option is out-of-the-money. This is a situation when the strike price is lower than the market price of the underlying.

When to sell put option

You don’t have to wait until the end of the expiry date to sell put option. It can be sold at any time before the end of the expiry date. It can be done to cut losses or book profits. If, for example, you feel that the stock or index in which you have a put contract will go up, you can maximise earnings or minimise losses by selling the option.

The option writer – the entity from whom you buy put option – also has the choice of getting rid of the option before the expiry. If the price of the underlying asset – stocks or indices – falls to near the strike price or below it, the option writer has the choice of repurchasing the option. To do that, he has to pay a premium to the buyer, since the put is now out-of-the-money. In this case, the loss the option writer makes is the difference between the premium paid to get out of the position minus the premium collected.

If, however, the price of the underlying asset is above the strike price, option writers may hold it until expiry since the contract would be worthless and they would be able to keep the whole premium.

So there are three ways in which a put trade can be settled. One is squaring off. This involves purchasing a call option for the same stocks or indices. Another is a physical settlement, where you sell the underlying shares. However, this is not possible for an index option since they are cash settled. The third option is to sell put options.

Put vs call option

Which is better for trading – put or call option? The answer to that question is not all that clear-cut. It all depends on your risk tolerance, the situation in the market, and your investment goals. If you expect prices of stocks to fall, then puts are a better choice. If prices are expected to fall, then you might be better off with call options.

How to trade put options in India

Now that you have understood what is a put option, you can go ahead and trade in them. Derivatives like put and call options are available on stock exchanges like the Bombay Stock Exchange and the National Stock Exchange. You can buy and sell futures and options through your broker, just like any other share. You can buy put and call options in indices like the Sensex, the Nifty and other sectoral indices. However, you must note that cannot trade in derivatives on all stocks. They are only available for about 175 shares listed on the exchange.