What is Put Option?

A put option is a financial contract that provides the holder with the right, but not the obligation, to sell a specified asset at a predetermined price within a specified time. A contractual agreement regulates the entitlement to sell. While stocks are frequently employed as the underlying securities, commodities, futures and currencies are also applicable. 

The predetermined price is termed the "strike price" since the expectation is to execute the option when the stock price reaches or falls below this level. The option can only be exercised until a specified date, referred to as the expiration date, as the choice becomes invalid after this date.

When to Buy a Put Option?

When you buy a put option, you ensure that your maximum potential loss is limited to the premium paid for the option. You compensate the individual willing to buy your stock with a nominal fee. The fee serves as coverage for their risk, as they acknowledge that you may exercise the option and require them to buy the stock at any point within the agreed-upon timeframe. 

Despite the possibility of the stock's value declining significantly on that specific day, they find it worthwhile because they anticipate an increase in the stock price. Similar to an insurance company, they prefer receiving the payment from you in exchange for the minor risk associated with buying the shares.

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Table of Content

  1. When to Buy a Put Option?
  2. When to Sell a Put Option?
  3. How Does a Put Option Work?
  4. Put Options Examples
  5. When Do You Buy A Put Option?
  6. Advantages of Put Options
  7. Is Buying a Put Similar to Short Selling?

When to Sell a Put Option?

When you sell a put option, you commit to buying a stock at a predetermined price.

If the stock price decreases, sellers incur losses because they are obligated to buy the stock at the strike price but can only sell it at a lower market price. Conversely, if the stock price increases, sellers make a profit because the buyer chooses not to exercise the option. The fee paid by the put buyers remains with the put sellers. 

To sustain their operations, sellers generate income by writing numerous options on companies they anticipate will see an increase in value. They believe that the fees earned will offset any losses incurred when stock prices decline.

How Does a Put Option Work?

When the value of the underlying stock or investment declines, the value of a put option increases. Conversely, a put option experiences a decrease in value when the underlying stock's price rises. Consequently, put options are commonly utilised for hedging or speculating on negative price movements. A risk management strategy, known as the protective put, often involves the use of put options.

This strategy functions as a form of investment insurance or hedge, ensuring that losses in the underlying asset do not surpass a predetermined threshold.

To hedge against downside risk in a stock within the portfolio, an investor employs the protective put strategy by purchasing a put option. In the event the option is executed, the investor has the option to sell the stock at the put's strike price.

Put Options Examples

If you wish to buy a put option for Britannia Industries stock with a strike price of Rs.3300 per share, anticipating a decline in the stock price to approximately Rs.3000 or Rs.2800 in the next six months, you would buy a put option.

For instance, let's assume Britannia Industries is currently priced at Rs.3200/-. The buyer of the contract secures the right to sell Britannia to the seller of the contract at Rs.3300/- upon the contract's expiration. To obtain this right, the buyer must pay a premium to the seller. In return for the premium, the seller commits to buying Britannia Industries shares at Rs.3300/- upon expiration, but only if the buyer decides to exercise this option.

After buying the put option for Britannia, there are three possible scenarios

  • If the stock price rises to Rs.3500 upon expiration, it wouldn't be logical for the buyer to exercise the right and ask the seller to buy the shares at Rs.3300. This is because the buyer can sell the shares at a higher market rate.
  • Suppose Britannia's stock price falls to Rs.2800 upon expiration. In that case, the buyer can demand the seller to buy Britannia at Rs.3300. This allows the buyer to benefit from selling Britannia at Rs.3300 when the market price is lower at Rs.2800.
  • If the stock price remains at Rs.3300 upon expiration, the buyer may choose not to exercise the option, as there is no advantage in selling at the agreed-upon price when the market price is the same.

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When Do You Buy A Put Option?

When you buy a put option, you ensure that your potential losses are limited to the premium paid for the option. You compensate the individual willing to buy your stock with a nominal fee.

The fee serves as protection for their risk. They understand that you can exercise the option at any point within the agreed-upon timeframe, even if the stock's value decreases significantly on that specific day. Despite this risk, they find it worthwhile because they anticipate the stock price will increase. Similar to an insurance company, they prefer receiving the money from you in exchange for assuming the modest risk of acquiring the shares.

Advantages of Put Options

Deciding whether to invest in a put or call option is crucial when purchasing an options contract, and understanding the respective advantages is essential. In direct comparison, a put option holds more benefits than a call option.

Market Dynamics and Value Fluctuations

The underlying asset or stock of an option is susceptible to various movements influenced by social, economic, and political events. This dynamic nature leads to significant value fluctuations. For a call option to yield profits, an investor must acquire the option at a price lower than the strike price.

Profitability in Stable or Declining Markets

Conversely, investors in put options can generate profits if the underlying asset's price remains stable or experiences a slight decline. Consequently, a put option trader stands a higher chance of profitability compared to a call option trader in scenarios where the market is not experiencing strong upward movements.

Time Decay Advantage

Time is a critical factor in options trading, favouring sellers. As an option contract approaches its specified duration, its value diminishes. Put option sellers can profit from time decay by selling the contract while it remains valuable. On the other hand, holders of call options may face challenges as time decay works against them.

Implied Volatility Strategy 

The cost of an option contract is denoted as implied volatility, with higher implied volatility leading to a higher option contract price. Put option traders strategically sell when prices are high and buy when they are low. This strategy is particularly effective when implied volatility is initially high but gradually decreases over time. Historical observations suggest that high implied volatility tends to decline, providing opportunities for put option buyers to profit over time due to favorable market conditions.

Is Buying a Put Similar to Short Selling?

Buying a put option and short selling are both financial strategies used by investors to profit from anticipated declines in the value of an underlying asset. Still, they differ fundamentally in their mechanics and risk profiles. When an investor buys a put option, they are essentially purchasing the right, but not the obligation, to sell a specified quantity of the underlying asset at a predetermined price (strike price) within a set time frame (expiration date). This strategy provides a form of insurance against potential price drops, allowing the investor to sell the asset at a higher predetermined price, regardless of its current market value. The risk in buying a put option is limited to the premium paid for the option, making it a more controlled and predictable approach.

In contrast, short selling involves borrowing an asset from a broker and selling it on the market with the expectation that its price will decline. The short seller later repurchases the asset at the lower market price, returning it to the lender and pocketing the difference in price as profit. However, short selling exposes the investor to theoretically unlimited risk, as there is no ceiling on how high an asset's price can rise. Short sellers may also face additional costs, such as borrowing fees and potential margin calls, further amplifying the risk and complexity of the strategy.

Conclusion     
A put option serves as a powerful financial instrument that empowers investors to manage risk and capitalise on market movements. Through the purchase of a put option, an investor gains the right, but not the obligation, to sell an underlying asset at a predetermined price within a specified timeframe. Knowing what is put option, and its advantages, helps you in multiple ways. This flexibility is particularly valuable in volatile markets, where price fluctuations can be unpredictable. The versatility of put options makes them a useful tool for investors seeking to navigate the uncertainties of the stock market, and you can check different options contracts from the stock market app.

FAQs on Put Options

Put and call options are financial instruments that provide investors with the right, but not the obligation, to sell (put) or buy (call) a specified asset at a predetermined price within a set time frame.

If you buy a put option, you acquire the right, but not the obligation, to sell a specified asset at a predetermined price within a set time frame. This provides a hedge against potential declines in the asset's market value.

While put options are commonly used for hedging, they can also be employed for speculative purposes to profit from anticipated declines in asset prices.

Investors use put options to hedge against potential market downturns, providing a form of insurance for their portfolios or for speculative purposes to profit from anticipated declines in asset prices.

Put options can be traded on various assets, including stocks, commodities, and indices, providing flexibility for investors to hedge or speculate on different markets.