Put Options Basics and How They Work in Practice?

Post Date : January 17, 2025

Put Options Basics and How They Work in Practice?

Disclaimer:-Investments in the securities market are subject to market risks. This content is for Educational purposes only and does not constitute financial advice

Topics Covered

• What is a Put Option?
• How Do Put Options Work?
• Buying a Put Option
• Selling a Put Option
• Put vs. Call Option
• How to Trade Put Options in India

What is a Put Option?

A put option gives the holder the right to sell an underlying asset at a specified strike price before the expiration date. This tool is particularly useful for:

• Hedging against a potential decline in an asset’s price.
• Speculating on price drops without directly short-selling the asset.

If the market price of the underlying asset falls below the strike price, the put option gains value. Conversely, if the price stays above the strike price, the put option may expire worthless, and the holder only loses the premium paid.

How Do Put Options Work?

Put options derive their value from the underlying asset’s price movements:

• If the price falls below the strike price, the put option becomes more profitable.
• If the price rises above the strike price, the option loses value.

A common strategy involving put options is the protective put, which acts like insurance for investors. For instance:

• If an investor holds a stock and anticipates a price decline, they can buy a put option to limit potential losses.
• Traders without ownership of the stock can use puts to create short positions, benefiting from falling prices.

Buying a Put Option

Buying a put option provides downside protection for an investor. If the price of the underlying asset falls below the strike price, the put buyer can sell the asset at the higher strike price, effectively maintaining a short-like position.

Example:
Imagine a stock priced at ₹50. A put option with a strike price of ₹50 costs ₹3 per share (₹300 per lot of 100 shares) and expires in six months. If the stock’s price falls to ₹40:

• The buyer can sell the stock at ₹50, making ₹10 per share (₹1,000 for 100 shares).
• After deducting the premium (₹300), the net profit is ₹700.

If the stock price stays above ₹50, the buyer only loses the ₹300 premium.

Selling a Put Option

Selling put options is a strategy where the seller earns a premium upfront, betting that the asset’s price will remain the same or rise.

• If the asset’s price drops below the strike price, the seller must buy it at the strike price, potentially incurring a loss.
• If the price stays the same or rises, the seller keeps the premium as profit.

This strategy is suitable for investors interested in owning the underlying asset at an attractive price.

Put vs. Call Option

The choice between a put and a call option depends on your market outlook and risk tolerance:

• Put Option: Suitable if you anticipate a price drop.
• Call Option: Ideal for scenarios where you expect the price to rise.

Both tools are complementary and cater to different trading objectives.

How to Trade Put Options in India

Trading put options in India is straightforward and accessible through major stock exchanges like the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). Here’s how to get started:

1. Open a trading and Demat Account with brokers like RMoney.
2. Choose from a range of derivatives available on indices (e.g., Nifty, Sensex) and specific stocks.
3. Execute your trades through the exchange’s derivatives segment.

Note: Derivatives trading is only available for a select list of approximately 175 securities. (List keeps on updating as per SEBI’s direction)

FAQs

Q1. What happens when you execute a put option?

If you’re the buyer, you sell the asset to the seller at the strike price. If the contract expires out of the money (OTM), no action is taken, and the seller retains the premium.

Q2. When should you exit a put option?

You can exit a put option before expiration by selling it (if you bought the option) or repurchasing it (if you sold the option).

Q3. What happens if you don’t sell options on expiry?

Options expire worthless if they are OTM. For sellers, this means keeping the premium, while buyers lose the premium paid.

Q4. Is it better to exercise or sell an option?

Exercising an option is ideal if you wish to own or sell the underlying asset. However, many traders prefer selling the option to book profits.

Q5. How much can you lose on a put option?

For buyers, the loss is limited to the premium paid. For sellers, potential losses can be substantial if the price drops significantly.

Q6. Can you exercise a put option before expiration?

Yes, but it’s uncommon. Most traders prefer to sell their position before expiry to capitalize on market movements.

Conclusion

Put options are versatile financial instruments that serve as valuable tools for hedging and speculation. Whether you’re looking to protect your investments or profit from a market downturn, understanding the mechanics of put options is essential. With platforms like RMoney, trading put options in India has become easier than ever. Ensure you understand the risks and benefits before engaging in options trading.