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 the put option meaning, what is put in the share market, how does put option works, its advantages, and more. 

How Does a Put Option Work?

After understanding what is a put option let’s learn about how a put option works. 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 used 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.

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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, the buyer finds it worthwhile because they anticipate that the stock price will increase. Similar to an insurance company, the buyer prefers receiving the payment from you in exchange for the minor risk associated with buying the shares. 

Example:

Suppose you buy a put stock option in Britannia Industries at an exercise price of ₹3300 per share. You have been expecting that during the next six months, the market price of stock is likely to fall to around ₹3,000 or ₹2,800. The current market price of Britannia Industries is ₹3200. You buy the put option. With this, you have obtained the right to sell Britannia at ₹3300 on its expiry. Since the stock price has fallen to ₹2800 after expiration, you can exercise the option. The option now has given you the right to sell Britannia at ₹3300 when the market price is ₹2800. 

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When to Sell a Put Option?

When selling a put option, the seller commits to buying a stock at a predetermined price. If the stock price decreases, the seller incurs losses. This happens because the seller is 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, the seller makes 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. Sellers believe that the fees earned will offset any losses incurred when stock prices decline. 

Example: Assume you have sold a put option of Britannia Industries with a strike price of ₹ 3300 when the market price is ₹ 3200. Now if the stock price goes up to ₹ 3500, the buyer will not exercise this put option. You get to retain your premium which you earned from selling this put option. But on the other hand, when the stock trades down at ₹ 2800, you have bought it at ₹ 3300, when its market value is less. 

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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.

Difference Between Put Option and Call Option

Following are the differences between Put Options and Call options.
 

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 gaining from the price difference. 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 capitalize 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, 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.