What Are Put Options And How To Trade Them?

India has a steadily growing derivatives trading market regulated by SEBI. Derivatives are financial contracts that derive their value from an underlying asset or a benchmark.  Options are one of the most popular categories in the derivatives segment. An option gives an absolute right to a party to either buy or sell its underlying assets. The party is not obligated but free to make a decision. There are two types of options — call and put options. This article helps you understand what put options are and how to trade them.  

What are Options?

Options are derivatives contracts that by themselves do not have any value. They derive their value from underlying securities like stocks, commodities, currencies, etc. Any movement in the price of these assets will lead to similar changes in options contracts.  

What is a Put Option? 

Put Option is a contract between two parties – a buyer and a seller; this gives the buyer a complete right over whether he/she wants to sell their underlying stock or not. 

The buyer is not obligated to sell; he/she has every right to refuse to participate in such a transaction. If he/she does not sell the underlying assets as per the put options contract, he/she will incur a loss equivalent to the premium amount paid.

However, if this buyer decides to exercise his/her right to sell these assets, the options seller will have no choice but to purchase the same. In doing so, the buyer of the option stands a chance to earn significant profits. Investors generally opt for put options when markets tend to be bearish.   

How do Put Options Work? 

Put options contracts work in a similar manner to call options. One may take up these contracts when there are bearish signs in the markets or for a particular stock. Investors would want to take advantage of the same and earn decent returns. 

Let’s understand the working of put options with an example. Mrs Trivedi thinks that the government will come up with a new tax on petrochemicals in the coming Union budget. It will affect Company ABC, and its shares are likely to see a fall from their present value. 

The current trading price of ABC is Rs. 500. Mrs Trivedi expects this to fall to Rs. 480. Hence, she opts for a put option with a strike price of Rs.480. According to calculations, after taking into account the contract lot size and a premium per share, she will have to shell out a premium of Rs.7,000 for buying this put option. 

One must remember one thing Mrs Trivedi can exercise her put option on any date before the expiration date. She must thoroughly monitor the stock prices of ABC as she may get an ideal opportunity to exercise the put option even before its expiry date. 

In case the price of the stock falls to Rs.480 or even lower than that, she will exercise her right to sell the stock and earn profits. However, if the price does not fall to Rs. 480 or below it, she can simply not sell the underlying stocks of ABC. In such a scenario, she will have to incur a loss which is limited to a premium amount of Rs.7,000 only.

What is a Stock Put Option? 

Stock put options are those options contracts that derive their value from an underlying stock. Traders use the movement in stock prices and exercise their put options at an appropriate time to earn profits. The stock option can be profitable only when the price of the underlying shares is falling. 

Also Read: What Is Option Trading And How Does It Work?

Types of Put Options 

Here are two types of options contracts available for trading:

• Short put
  Under this position, a trader will sell or write his/her put option and underlying stocks. He/she is called a seller or writer in financial parlance. On selling the underlying stocks, he/she is liable to receive a premium which would be his/her profit from the trade. 
  
  In the case of short put trading, one will receive profits only if the price of the underlying securities rises or stays the same. If the prices of underlying securities fall, they will start incurring losses. 

• Long put
  In a long put, a trader purchases a put option with a bearish view on the underlying assets. The main motive behind this is to buy an option and execute it at a later stage to make profits. 
  
  Under this strategy, a trader can make profits when the price of the assets falls below a certain level by selling the stocks at the strike price. This is the price at which the buyers can exercise their right to sell the asset. 
  
  On the other hand, traders will suffer downside losses if the price of the underlying assets starts rising. This loss would be the premium amount paid by him/her. Traders often go for this position for purely speculative reasons.  

When Should You Trade Put Option?

Individuals prefer buying put options when there are bearish or negative sentiments around a sector or markets as a whole. Traders profit from buying it when the prices of underlying stocks or securities fall. 

This may happen due to underperformance of the company in a quarter or unfavourable policy on the part of the government or any other external factor. Therefore, an ideal case for buying them is when one anticipates a fall in the price of the underlying securities. 

When to Buy?

Investors prefer buying put options when there are bearish or negative sentiments around a sector or markets as a whole. Traders profit from buying it when the prices of underlying stocks or securities fall.

This may happen due to underperformance of the company in a quarter or unfavourable policy on the part of the government or any other external factor. Therefore, an ideal case for buying a put option is when one anticipates a fall in the price of the underlying securities. 

When to Sell? 

Traders can opt to sell their put contracts when there are bullish or optimistic tendencies in the market. Those involved in selling the put option will profit only when the current trading price is higher than the spot price. One must go for selling it when they think that the market won’t fall further or it will remain flat.

How to Settle Put Options? 

There are three ways of settlement for put options contracts. These include squaring off one’s position, physical settlement and selling of contracts. In the case of squaring off, one holds a contract for selling stock and at the same time purchases a contract to buy the same stock. 

The physical settlement involves taking physical delivery of shares in their trading or Demat account. One can also sell the put options contract if it results in profits. 

Also Read: Mutual Funds Vs Stocks: 8 Key Differences Between Stocks Vs Mutual Funds

Difference between Put and Call Option

These two options are two sides of the same coin. The backbone on which they work is different from each other. First, let’s consider the difference on the basis of what put and call options are? Call options allow traders the right to buy an underlying stock at a fixed price on or before its expiration date. On the other hand, put options allow traders to exit their positions at a predetermined price. 

Secondly, the market conditions required to make profits with put and call options are completely different. Individuals will only go for call options when there are bullish conditions for a particular stock or in the whole market. Similarly, traders will opt for put options when they have a bearish sentiment.  

The value of call options will move upward if the price of underlying stocks increases. However, in the case of put contracts, this value falls if there is an upward movement in stock price. 

Final Word

Put options are a popular form of derivatives in the F&O segment. It has huge potential for exponential profits with minimum capital required to invest in them. However, due to their nature of speculation and volatility, they are riskier trading alternatives. Traders must be very careful while opting for any of these. 

FAQs on Put Options