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Understanding How Put Options Work

Understanding How Put Options Work

Put options are commonly used as a hedging tool against potential losses in the underlying asset or as a way to profit from a decrease in the asset's value. The price of a put option is affected by factors such as the price of the underlying asset, the strike price, time until expiration, and market volatility. Read this article to better understand how put options work.
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  • 07 Feb 2023
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In any market, there cannot be a buyer without there being a seller. Similarly, in the Options market, you cannot have call options without having put options. Puts are options contracts that give you the right to sell the underlying stock or index at a pre-determined price on or before a specified expiry date in the future.

In this way, a put option is exactly opposite of a call option. However, they still share some similar traits.

For example, just as in the case of a call option, the put option’s strike price and expiry date are predetermined by the stock exchange.

Here are some key features of the put option:

  • Fix the strike price -- amount at which you will buy in future
  • Chose the expiry date
  • Select option price
  • Pay option premium to broker
  • Broker transfers to exchange
  • Exchange sends the amoun to option seller
  • Initial margin
  • Exposure margin
  • Premium margin/assignment margin
  • Stock call options
  • Index call options
  • Buyer of option pays you amount through brokers and the exchange
  • Helps reduce you loss or increase profit.

Here Are Some Key Features Of The Call Option:

  • Specifics: To buy a ‘call’ option, you have to place a buy order with your broker specifying the strike price and the expiry date. You will also have to specify how much you are ready to pay for the call option.

  • Fixed Price: The strike price for a call option is the fixed amount at which you agree to buy the underlying assets in the future. It is also known as the exercise price.

  • Option Premium: When you buy the call option, you must pay the option writer a premium. This is first paid to the exchange, which then passes it on to the option seller.

  • Margins: You sell call options by paying an initial margin, and not the entire sum. However, once you have paid the margin, you also have to maintain a minimum amount in your trading account or with your broker.

  • Premium: Stock and Index Options: Depending on the underlying asset, there are two kinds of call options – Index options and Stock options. Option can only be exercised on the expiry date. While most of the traits are similar .

  • Seller’s Premium: You can also sell off the call option to another buyer before the expiry date. When you do this, you receive a premium . This often has a bearing on your net profits and losses.

When Do You Buy A Put Option:

There is a major difference between a call and a put option – when you buy the two options. The simple rule to maximize profits is that you buy at lows and sell at highs. A put option helps you fix the selling price. This indicates you are expecting a possible decline in the price of the underlying assets. So, you would rather protect yourself by paying a small premium than make losses.

This is exactly the opposite for call options – which are bought in anticipation of a rise in stock markets. Thus, put options are used when market conditions are bearish. They thus protect you against the decline of the price of a stock below a specified price.

Kinds Of Put Options:

There are two kinds of put options – American and European – on the basis of when an option can be exercised. American options are more flexible; they allow you to settle the trade before the expiry date of the contract. European options can only be exercised on the day of the expiry. Thus, index options are European options, while stock options are a kind of American options.

Illustration Of A Put Index Option

Suppose the Nifty is currently trading at 6,000 levels. You feel bearish about the market and expect the Nifty to fall to around 5,900 levels within a month. To make the most of your view of the market, you could purchase a 1-month put option with a strike price of 5900. If the premium for this contract is Rs 10 per unit, you will have to pay up Rs 1,000 for the Nifty put option (100 units x Rs 10 per unit).

So, if the index remains above your strike price of 5,900, you would not really benefit from selling at a lower level. For this reason, you would chose to not exercise your option. You just lose your premium of Rs 1,000.

However, if the index falls below 5,900 levels as expected to say 5,850 levels, you are in a position to make profits from your options contract. You will thus choose to exercise your option and sell the index. That said, remember to take into consideration your premium costs. You will need to recover that cost too. For this reason, you will start making profits only once the index level falls below 5,890 levels.

Illustration Of A Put Stock Option

Put options on stocks also work the same way as call options on stocks. However, in this case, the option buyer is bearish about the price of a stock and hopes to profit from a fall in its price.

Suppose you hold ABC shares, and you expect that its quarterly results are likely to underperform analyst forecasts. This could lead to a fall in the share prices from the current Rs 950 per share.

To make the most of a fall in the price, you could buy a put option on ABC at the strike price of Rs 930 at a market-determined premium of say Rs 10 per share. Suppose the contract lot is 600 shares. This means, you have to pay a premium of Rs 6,000 (600 shares x Rs 10 per share) to purchase one put option on ABC.

Remember, stock options can be exercised before the expiry date. So you need to monitor the stock movement carefully. It could happen that the stock does fall, but gains back right before expiry. This would mean you lost the opportunity to make profits.

Suppose the stock falls to Rs 930, you could think of exercising the put option. However, this does not cover your premium of Rs 10/share. For this reason, you could wait until the share price falls to at least Rs 920. If there is an indication that the share could fall further to Rs 910 or 900 levels, wait until it does so. If not, jump at the opportunity and exercise the option right away. You would thus earn a profit of Rs 10 per share once you have deducted the premium costs.

However, if the stock price actually rises and not falls as you had expected, you can ignore the option. You loss would be limited to Rs 10 per share or Rs 6,000.

Illustration Of Put Stock Option

Thus, the maximum loss an investor faces is the premium amount. The maximum profit is the share price minus the premium. This is because, shares, like indexes, cannot have negative values. They can be value at 0 at worst.

What Are The Payments And Margins Involved In Buying And Selling Put Options:

Whether you are a buyer or a seller, you have to pay an initial margin as well as an exposure margin. In addition to these two, additional margins are collected. These differ for buyers and sellers, who are at the opposite ends of the spectrum.

Here’s a look:

  • Buying Put Options:

Whether you are a buyer or a seller, you have to pay an initial margin as well as an exposure margin. In addition to these two, additional margins are collected. These differ for buyers and sellers, who are at the opposite ends of the spectrum.

  • Selling Put Options: As a seller or writer of a put option, your potential loss is unlimited. This is because prices can rise to any heights theoretically, and as a put option writer, you have to buy at whatever price has been specified.

For this reason, the buyer of a put option has limited liability – the premium amount, while the seller has a limited gain. Therefore, the seller of a put option has to deposit a higher margin with the exchange as security in case of an adverse movement in the price of the options sold. This is called assignment margin.

Just like the call option, the margins are levied on the put contract value in percentage terms. This amount the seller has to deposit is dictated by the exchange. Margin requirements typically rise during period of higher volatility.

So, the seller of a put option of ABC at a strike price of 970 with margin requirement of 20%, who receives a premium of Rs 10 per share, would have to deposit a margin of Rs 1,16,400 (20% of 970 x 600) as against the total value of his outstanding position of Rs 5,82,000.

There are three common ways to settle put options contracts.

Types Of Margin Payments:

  • Squaring Off: In the case of Stock options, you can buy an opposing contract. This means, if you hold a contract to sell stocks, you purchase a contract to buy the very same stocks. This is called squaring off. You make a profit from the difference in prices and premiums.

  • Selling If none of the above options seem profitable, you can simply sell the ‘put’ option you hold. This is also a kind of squaring off method.

  • Physical Settlement: You can also exercise your option anytime on or before the expiry date of the contract. This means, you will actually sell the underlying stocks as specified in the options contract agreement.

For put index options, you cannot physically settle, as the index is not tangible. So, to settle index options, you can either exit your position through an offsetting trade in the market. You can also hold your position open until the option expires. Subsequently, the clearing house settles the trade.

Now let’s see how this differs if you are a buyer or writer put options:

  • For A Buyer Of A Put Option: If you decide to square off your position before the expiry of the contract, you will have to buy the same number of call options of the same underlying stock and maturity date. If you have purchased two XYZ put options with a lot size 500, a strike price of Rs 100, and expiry month of August, you will have to buy two XYZ call options contracts with an expiry month of August. Thus, these two cancel each other. Whatever is the difference in strike prices could be your profit or loss. You can also settle by selling the two put options contracts you hold in order to square off your position. This way, you will earn a premium on the contracts as the seller. The difference between the premium at which you bought the put option and the premium at which you sold them will be your profit or loss. Or, you can exercise your options on or before the expiration date. The stock exchange will calculate the profit/loss on your positions by measuring the difference between the closing market price of the share or index and the strike price. Your account will be then credited or debited for the amount. However, your maximum loss will be restricted to the premium paid.

  • For The Seller Of A Put Option: If you have sold put options and want to square off your position, you will have to buy back the same number of put options that you have written. These must be identical in terms of the underlying asset (stock or index) and maturity date to the ones that you have sold. In case the options contract gets exercised on or before the expiration date, the stock exchange will calculate the profit/loss on your position. This will be based on the difference between the strike price and the closing market price of the stock or index on the day of exercise. You losses will be adjusted against the margin that you have provided to the exchange and the balance margin will be credited to your account with the broker.

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