The equity market is extremely volatile – changes rapidly with the market news. Traders know it, and that is why they use different types of financial instruments to diversify their portfolio and shield their investment against loss. A stock option is popularly used by investors to hedge against future price movements of an underlying asset. It is a contract, non-obligatory though, to enable investors to buy or sell stocks at an agreed-upon price or date. It has two varieties – call and put; with characteristics opposite to each other. In this article, we will discuss put options and how to trade with it.
What is a Put Option?
A put option is a contract. Investors buy put options when their outlook is bearish about the market. It allows them to protect their investment against downward price changes. Though it’s a contract, it is not legally binding. The owner can decide not to exercise the deal based on market trends. Investors use put options when market trends are bearish, and prices are expected to fall. It allows them to minimize their losses.
Put options are traded on various underlying assets, including securities, currencies, bonds, commodities, indexes, and futures. Its prices are affected by the price change of the underlying asset – fall in asset price will increase the value of the put option.
On the opposite side of it lies the call option. It allows investors to buy an asset at a predetermined price and date.
Components of a Put Option
- Asset – Commodity on which the option contract is drawn.
- Date of Expiration – A future date when the owner is required to execute the option.
- Strike Price – It’s a predetermined price at which the seller will sell the underlying option.
- Premium – Premium of an option is the price that the buyer or seller pays for the contract. Intrinsic value, time value, and the implied volatility are the three critical components that influence the premium price of an option.
Price of a put option has two components – its intrinsic value and time-frame value. Its time value decreases as it approaches the expiration date due to time decay. Because with time, the probability of a stock price to fall below strike price reduces.
How does a put option work?
Put options shield seller from the decreasing price of an underlying asset. So the value of it increases as the price of an asset decreases. Conversely, its value decreases if asset price rises. It happens because put options are drawn to hedge against anticipated price fall. So, when the price of an asset rise, it becomes less valuable since the seller will not sell at a lower price. It works as investment insurance guaranteeing that loss doesn’t exceed strike rate.
When a put option loses its time value, only its intrinsic value remains, which is the difference between the strike price and underlying asset price. If the difference is positive, the option is said to be in the money (ITM). The other two situations are out of the money (OTM) and at the money (ATM). Put options that are OTM or ATM have no value. Often, traders, short sell put options at higher market prices to avoid OTM and ATM situations.
On the other hand, the time value of a put option, also called the extrinsic value, is reflected in its premium. Let’s understand it with an example.
Let’s say the strike price of a put option is Rs 100. Cost of the underlying asset is Rs 98. So, intrinsic value of the option is Rs 2. Now if you buy put option for Rs 2.50. The extra 0.50 is its time value.
Buying puts involves risk. Make sure you fully understand how the options market functions before you trade in it. Here are a few more things to understand about buying puts.
– It involves two players – contract buyer and contract seller, one who pays the premium is called the buyer and the other, seller
– The buyer obtains the right of the contract
– If the buyer decides to exercise his rights, then the seller is required to honour the contract
– The contract buyer is likely to execute the contract when the underlying asset price is lower than the strike price.
– Both the seller and the buyer aren’t obligated to hold the contract till the expiration date
– Profit or loss from a put option is the difference between the intrinsic value and the premium paid. If the value is positive, the buyer is said to be in profit.
Options market behave differently than the equity market, and it is a bit complex. It will take one some time to understand how to earn profit from options trading.