What is a Put Option?
Put options are a type of financial instrument within options trading that give you the right, but not the obligation, to sell a specific asset at a predetermined price within a set period. They are a type of financial derivative, meaning their value is derived from an underlying asset, such as stocks, commodities, or indices. Put options are commonly used by investors and option traders to protect against potential price declines in an asset or to speculate on the asset’s price falling.
When you purchase a put option, you are essentially betting that the price of the underlying asset will decrease before the option expires. If the price of the asset falls below the predetermined price, known as the strike price, you can exercise your put option and sell the asset at the higher strike price, thus making a profit. On the other hand, if the price of the asset remains above the strike price, you can simply let the option expire, limiting your losses to the premium you paid for the put option.
Example:
Example: Purchase a long put option with a ₹1000 strike price for ₹50 premium. The maximum loss is the premium paid, i.e ₹50 , but profit potential is boundless until the stock reaches $0. However, the stock must fall below ₹950 at expiration to realize a profit.
When should you buy a Put Option?
If you believe that a specific stock or asset is going to decrease in value in the future, buying a put option can be a smart move. Here are some scenarios when you might consider buying a put option:
- Hedging against a downside: Buying a put option can act as insurance for your investment portfolio. If you hold a substantial amount of a particular stock and want to protect yourself against potential losses if the stock price drops, purchasing a put option can help mitigate that risk.
Example:
Let’s say Raj owns 100 shares of XYZ Company, currently trading at ₹1,000 per share. Raj is concerned that the stock price might fall in the near future due to market volatility, but he doesn’t want to sell his shares just yet. To protect (hedge) his investment, Raj can buy a put option.
Scenario: Hedging with a Put Option
Raj decides to buy a put option with a strike price of ₹1,000, which costs ₹50 per share, and it expires in one month. This put option gives Raj the right to sell his 100 shares of XYZ Company at ₹1,000 per share, even if the market price drops below this level.
Breakeven Point: The breakeven point for Raj’s hedge would be:
- Strike Price – Premium Paid = ₹1,000 – ₹50 = ₹950
How Hedging Works:
If the Stock Price Falls:
- Suppose the stock price drops to ₹900 by the expiration date. In this case, Raj can exercise his put option and sell his 100 shares at ₹1,000 each, even though the market price is ₹900.
- His profit from the put option would be:
- Sell Price (from the put option): ₹1,000
- Market Price: ₹900
- Premium Paid: ₹50
- Profit per share = ₹1,000 – ₹900 – ₹50 = ₹50
- Total profit from the hedge = ₹50 x 100 shares = ₹5,000
This profit offsets the loss in the value of his shares, effectively protecting his investment.
If the Stock Price Stays Above ₹1,000:
If the stock price stays above ₹1,000 by the expiration date (e.g., it remains at ₹1,000 or rises to ₹1,100), the put option expires worthless, and Raj loses the ₹50 premium he paid per share.
However, the good news is that Raj’s shares have either maintained their value or appreciated. His maximum loss in this scenario is limited to the premium paid for the put option, which is ₹5,000 for 100 shares.
- Speculating on a price decline: If you have a strong hunch that a stock is overvalued and that its price is likely to fall, buying a put option can be a way to profit from that decline. This strategy allows you to benefit from falling prices without actually owning the stock.
- Market volatility: During periods of heightened market volatility or uncertainty, buying a put option can be a prudent move. Put options tend to increase in value as stock prices fall, making them a valuable tool for managing risk during turbulent market conditions.
When should you sell a Put Option?
If you expect the price of the underlying asset to stay stable or increase, a short put option strategy—selling a put option—can be a profitable approach. Here are some situations where selling a put option might be a smart choice:
- Bullish outlook: When you are bullish on a stock, selling a put option can allow you to profit from the stock price rising or staying the same.
- Time Decay: As the expiration date of the option approaches, the time value of the put option decreases. By selling a put option, you can benefit from time decay working in your favour.
Key difference between a Put Option and a Call Option
| Aspect | Put Option | Call Option |
|---|---|---|
| Right to | Sell an asset | Buy an asset |
| Profit Direction | Profits from price decrease | Profits from price increase |
| Buyer’s Outlook | Bearish | Bullish |
| Seller’s Outlook | Bullish | Bearish |
Benefits of Put Options
- Profit from price declines: Put options allow you to profit from a decrease in the price of an underlying asset. This serves as a form of insurance for your investments, especially during market downturns.
- Limited Risk: When you buy a put option, your risk is limited to the premium paid for the option. This can help you manage and control potential losses in a declining market.
- Portfolio diversification: Put options can be used as part of a diversified investment strategy to hedge against potential losses in other parts of your investment portfolio. This can help reduce overall portfolio risk.
- Low initial investment: Put options typically require a lower initial investment compared to short selling the underlying asset. This makes them a cost-effective way for investors to protect their portfolios or speculate on downward price movements.
FAQs
- Can anyone trade put options? Yes, anyone with a brokerage account can buy a put option.
- How much do put options cost? The cost of a put option is called the premium, and it varies depending on factors like the stock price, strike price, and expiration date.
- What happens if the stock price goes up after I buy a put option? If the stock price goes up, your put option may decrease in value or even become worthless.
- Can I sell my put option before it expires? Yes, you can sell your put option at any time before it expires, either for a profit or loss.
- Are put options risk-free? No, put options involve risk, including the risk of losing the entire premium paid for the option. Make sure to understand the risks before buying put options.
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