What is Put Option?

A put option is a financial contract that gives the holder the right, but not the obligation, to sell a specified asset at a predetermined price within a specified time. A contractual agreement regulates the right 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. Read on to learn more about what is put option meaning, with an example, how a put option works, its advantages, and more.   

How Does a Put Option Work? 

This is how a put option works for both buyers and sellers.  

Put Option for Buyers 

• The buyer expects the price of the underlying asset to fall below the strike price. 
• The buyer pays a premium to the seller to acquire this right. 
• If the market price falls below the strike price, the buyer can exercise the option and benefit from the price difference. 
• If the price stays above the strike price, the buyer may let the option expire, limiting the loss to the premium paid. 

Put option for Seller’s  

• The seller receives the premium upfront from the buyer. 
• The seller is obligated to buy the underlying asset at the strike price if the buyer exercises the option. 
• If the market price remains above the strike price, the option expires worthless, and the seller keeps the premium as gain. 
• If the price falls significantly, the seller may incur losses, as they must buy the asset at a higher strike price than the market value. 

After understanding what is put in share market and how it works, let’s understand when an investor can buy a put option.  

When to Buy a Put Option? 

In the share market, a put option is bought when investors expect prices to fall or want to protect their investments. Investors can buy a put option in the following conditions. 

• Expecting a price fall: A put option may be purchased when the investor thinks that the stock or index price will decrease in the near future. 
• Protecting an existing investment (hedging): In the market, investors tend to purchase put options as a way of guarding their current stocks against downside risk. 
• Market uncertainty or weakness: A put option can be applied in bearish markets or when the market is likely to be influenced adversely by market news. 
• Limited risk preference: Since the maximum loss is limited to the premium paid, put options may suit investors who want controlled risk. 

Here’s an example for better understanding: 
Suppose a stock is trading at ₹1,000. An investor is expecting its price to fall, so they buy a put option with a strike price of ₹980 by paying a premium of ₹20. If the stock falls to ₹900, then the investor can sell it at ₹980 and make gains (excluding premium). If the stock stays above ₹980, the option expires worthless, and the loss is limited to ₹20. 

When to Sell a Put Option? 

Investors can sell a put option in the following circumstances. 

• Anticipating the price to be at the same level or to increase: Investors can sell a put option when they anticipate that the price of the stock or index will not fall below the strike price until the expiry date.
• Getting regular premium: In sideways markets or a slightly bullish market, the investors sell put options to receive the premium in the form of income.  
• Ready to purchase the stock at the discounted price: Selling a put may be helpful in case investors are confident in purchasing the stock at the strike price in the event of an option exercise.  
• Bullish or neutral market expectations: A seller of a put option is advantaged in cases where the market will not change. 

Here’s an example: A stock is trading at ₹1,000. Traders can sell a put option with a strike price of ₹950 and receive a premium of ₹25. If the stock stays above ₹950, the option expires worthless, and they can keep ₹25 as a gain. If the stock falls below ₹950, then they have to buy it at ₹950, while the premium helps reduce their effective purchase cost. 

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 stock option may benefit more 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, favoring 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. 

Disclaimer: All investments are subject to market risks, economic conditions, regulatory changes, and other external factors. Returns are not guaranteed and may vary based on market performance and investment tenure. Investors should assess their risk tolerance and financial objectives, conduct their own research, and consult a qualified financial advisor before making any investment decisions.   

Conclusion 

A put option serves as a powerful financial instrument that empowers investors to manage risk and capitalise on market movements. Purchasing a put option, gives an investor the right, but not the obligation, to sell an underlying asset at a predetermined price within a specified timeframe. Knowing what is a put option with an example, and its advantages, can help you in many 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.