What is a Put Option?

 A put option is a financial contract that grants the buyer the right, but not the obligation, to sell a specified amount of an underlying asset (such as a stock) at a predetermined price (called the strike price) within a defined time frame. Investors typically purchase put options when they anticipate a decline in the asset's price, as this allows them to profit from the decrease. Additionally, put options serve as a hedging tool, protecting against potential losses by offering insurance against falling asset values.

 

Example - Imagine you own a put option for stock XYZ with a strike price of Rs. 50. If the market price of the stock drops to Rs. 40, you can still sell your shares at Rs. 50 by exercising the option, profiting Rs. 10 per share (minus the cost of the option).

 

How it works

·     Buyer of the Put Option: If you buy a put option, you’re betting that the price of the asset will go down. If it

does, you can sell it at the higher strike price even though the market price is lower, making a profit.

·     Seller of the Put Option (Writer): The seller is obligated to buy the asset at the strike price if the buyer exercises the option. They typically collect a premium (payment) upfront when selling the option.

 

What is Strike price in an option?

In options trading, the strike price, also called the exercise price, is the predetermined price at which an option holder can buy or sell an underlying asset when exercising an options contract. The strike price is a key feature of an options contract and plays a vital role in determining the break-even point and assessing potential profits or losses.

 

The difference between the strike price and the underlying security's price determines if an option is "in-the- money" (ITM) or "out-of-the-money". For example, a call option is ITM if its strike price is lower than the market price, and a put option is ITM if its strike price is higher than the market price. ITM options have intrinsic value.

 

When choosing a strike price, traders can consider their risk tolerance and desired level of exposure. For example, conservative traders might prefer options with strike prices closer to the current market price, while traders seeking higher returns might consider out-of-the-money options.

 

What is Premium on options and how is it calculated?

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 put options, the premium decreases as the price of the underlying (stocks or indices) increases and vice versa.

 

Types of Put Options

·     American Put Options - An American put option can be exercised at any time before or on the expiration date. This flexibility is one of the key features of American options.

·     European Put Options - A European put option can only be exercised on its expiration date, not before. This lack of flexibility can make them cheaper than American options

 

Till 2010, all index options in India were European Options while all stock options were American options. However, post 2010 all options are only European Options in India. Although European Options can only be exercised on the expiration date, there is nothing stopping the holder of the option from squaring off the position in the secondary market, subject to availability of liquidity in the options contract.

 

What is In the Money, At the Money and Out of the Money Put Option?

·     In the money Put Options - An In-the-money put option is described as a put option whose strike price is higher than the current price of the underlying.

·     At the money Put Options - An At-the-money put option is described as a put option whose strike price is approximately equal to the spot price of the underlying assets.

·     Out of the money Put Options - An Out-the-money put option is described as a put option whose strike price is lower than the spot price of the underlying.

 

Advantages of Put Options:

§  Profit from Declining Prices - You can profit from a decrease in the price of the underlying asset. If you believe a stock or other asset is going to drop in value, buying a put option allows you to sell it at a higher strike price.

§  Limited Risk (for Buyers) - The most you can lose as the buyer of a put option is the premium (cost) you paid for the option. This limited downside makes put options attractive for risk management.

§  Hedging and Protection - Put options are commonly used as a hedging tool. For instance, if you own a stock and are worried about potential short-term losses, you can buy a put option as "insurance" to protect your investment.

§  Leverage - Put options offer leverage. With a relatively small premium, you control a larger position in the underlying asset. This can amplify gains if your prediction is correct.

§  Strategic Flexibility - Put options allow for a wide range of strategies. Beyond speculation, they can be used in various combinations with other options (like spreads) to manage risk, income, or potential profits.

 

Drawbacks of Put Options:

§  Premium Costs (for Buyers) - You need to pay a premium upfront to buy a put option, and this cost can reduce

your overall profit. If the underlying asset doesn’t move as expected, you could lose the entire premium.

§  Limited Time Frame - Options have expiration dates. If the underlying asset doesn’t decline in price before the

option expires, it becomes worthless, and you lose your premium. Timing is critical.

§  Complexity - For beginners, understanding how options work, along with their pricing models (like the Black- Scholes model), can be challenging. Factors like implied volatility and time decay (theta) impact option prices and can be tricky to grasp.

§  Potential Obligation for Sellers (Writers) - If you sell (write) a put option and it gets exercised, you’re obligated

to buy the underlying asset at the strike price, even if the market price has dropped significantly lower. This

can lead to substantial losses if not managed carefully.

§  Market Liquidity - Some options may have low trading volumes, leading to wide bid-ask spreads and difficulty in executing trades at favorable prices

 

 

Detailed Illustration of a European Put Option

 

Index: Nifty 50

Current level: 25000

Strike Price: 25000

Expiration Date: 1 month away

Premium (Cost of Option): Rs. 230 per option contract Lot size per option contract: 25

 

European Put Option Example:

Buyer’s Perspective:

The buyer of a European put option is confident that the stock will fall, but they can only exercise the option at expiration.

 

Scenario 1: Nifty 50 Index drops to 23000 after 1 month:

Profit per contract: 25000 (strike price) - 23000 (market price) = 2000 Total Profit: 2000 * 25 (1 lot) = Rs. 50,000

Net Profit After Premium: Rs. 50,000 - Rs. 5750 (230 *25) = Rs. 44,250

 

Scenario 2: Nifty 50 Index stays around 25000 levels or above after 1 month:

Since the Nifty level is around the strike price or higher, the put option expires worthless. The buyer loses Rs. 5750 premium amount.

 

 

Seller’s Perspective:

The seller of the European put option collects the Rs. 5750 premium with the expectation that the index will stay at or above 25000 level.

 

Scenario 1: Nifty 50 Index stays at or above 25000 level after 1 month

The option expires worthless, and the seller keeps the Rs. 5750 premium with no further obligations.

 

Scenario 2: Nifty 50 Index drops to 23000 after 1 month: The seller is obligated to buy the index at 25000.

Loss per contract: 25000 (strike price) - 23000 (market price) = 2000 Total Loss: 2000 x 25 (1 lot) = Rs. 50,000

Net Loss After Premium: Rs. 50,000 - Rs. 5750 = Rs. 44,250

 

How we can hedge our current equity holdings using Put options

 

Our current equity investment is approx. Rs. 50 Crs whose market value is around Rs. 74 Crs as on 31^st July 2024. We can hedge our holdings by buying put options wherein the holdings could be protected in case of any downfall in the market.

 

Following table shows the premium costs for various put options of Nifty 50 Index;

 

Current Nifty 50 Index level	25200	25200	25200	25200	25200
Strike price (A)	25000	25000	23000	23000	26000
Option type	At the money	At the money	Out of the money	Out of the money	In the money
Option contract Expiration Date	26-Sep-2024	26-Dec-2024	26-Sep-2024	26-Dec-2024	26-Sep-2024
Premium cost (Rs.) per option contract (B)	177.00	466.60	21.65	145.35	675.25
Lot size per option contract (C)	25	25	25	25	25
No. of lots purchased (D)	1000	1000	1000	1000	1000
Total premium (Rs.) to be paid (E)--------------- (B*C*D)	44,25,000	1,16,65,000	5,41,250	36,33,750	1,68,81,250
Total exposure (Rs.) through the option (F)---------------------- (A*C*D)	62,50,00,000	62,50,00,000	57,50,00,000	57,50,00,000	65,00,00,000
Premium cost as a % of the exposure (E/F)*100	0.71%	1.87%	0.09%	0.63%	2.60%

 

Inferences from the above table;

·       For the same strike price, the premium cost increases with the increase in time to expiration, however you are also protected from market downfall for a longer period

·       An out of the money put option is cheaper to buy as compared to at the money or in the money put options, however the gains will also be lesser

·       For a buyer of the put option, the maximum loss is the premium paid to buy the contract