Call and Put Option are two sides of the same coin. They represent two opposite views on the same stock. A call option buyer expects the share price to increase. Quite naturally, a put option buyer will expect the share prices to decrease.
Majority of investors believe that the only way to make money in the market is when the stock price increases. You buy a stock for Rs 100 and sell it for Rs 200, making Rs 100 as profit. Simple and easy.
But you will be surprised to know that you can make as much money when the stock prices fall. All you need to leverage this opportunity is an understanding of put options.
Before we understand the official definition of a put option, let us first understand what are options. Consider the following example –
I go to buy a saree and shortlist one costing Rs 20,000. But, before making such an expensive purchase, I want to explore other options. But I don’t want to lose out on this saree either. So, I pay the shopkeeper Rs 1,000 as a token to reserve this saree. I tell him that I will come back in three hours to buy the saree. If I don’t come back, he can keep the token. But he cannot sell this saree to anyone before three hours.
In this transaction –
- The underlying asset is the saree.
- Rs 1,000 is the premium I paid to reserve the right of purchase. This is non-refundable.
- Three hours is the expiry date.
- Rs 20,000 is the strike price.
Now pay attention … I have the right to buy this saree. But I can choose to not buy it if I find a better saree for a lower price. So, I am not obligated or forced to buy the saree. If I don’t buy this saree, my loss is the premium paid which is Rs 1,000.
But the seller does not have this freedom. He has to sell me the saree if I demand to buy it. This is because he has taken a premium from me. So, he is obligated to sell me the saree. He cannot say no.
So, an options contract gives the buyer the right but not the obligation to either buy or sell the underlying asset at a specific price on a specific date. But the seller has an obligation.
A call option gives you the right but not the obligation to buy the underlying asset. Whereas a put option gives you the right but not the obligation to sell.
The below table will help you remember the rights and obligations of call and put options.
|Type of Option||Buyer||Seller|
|Call Option||Right to Buy||Obligation to Sell|
|Put Option||Right to Sell||Obligation to Buy|
In this article, we will focus on put options. To learn about call options, watch the below video.
Now, you would be in a better position to understand the official definition of put options.
Definition of Put Options
Put option is a derivative contract between two parties wherein the buyer of the put option gets the right but not obligation to sell the underlying asset at a specific price on a specific date.
Key Terms Relating to Put Options
Let us now understand some key terms relating to put options.
- Representation: The symbol for put option is PE. The letter P stands for put option and E stands for European option.
- Buyer of Put Option: He buys the right to sell the underlying asset at a specific price on the expiry date.
- Put Option Writer or Seller: He is obligated (forced) to buy the underlying asset from the put option buyer.
- Underlying Asset: Stocks are the underlying asset in a put option contract. If you are buying a Nifty put option then the 50 nifty stocks are your underlying asset. If you are buying a put option on Reliance Industries, then the stock of Reliance Industries Ltd is the underlying asset.
- Spot Price: This is the price of the underlying asset in the cash market.
- Strike Price: This is the price at which you want to buy (call) or sell (put) the underlying asset in the future.
- Lot Size: Options can only be bought in lots like in a wholesale market. You cannot buy one or two items; you need to buy the entire lot. The lot size varies across stocks. For example: one lot of Infosys Ltd. options contract contains 600 shares. Whereas one lot of Tata Consultancy Services Ltd. has 300 shares only.
- Premium: This is the amount paid by the put option buyer to the put option seller. The total premium paid = premium * lot size
- Expiry: This is the date on which you will have to exercise your right. At any given time, an options contract will have three expiries- Near Month, Mid Month and Far Month. All options contracts expire on the last Thursday of the month.
- Trading: Options are traded on the National Stock Exchange (NSE).
- Types of Options: Options can be European or American. European options can be exercised on expiry date only. Whereas American options can be exercised any time before the expiry date. All Indian options are European in nature. This means that you can exercise them on expiry only.
The image above shows a put option contract on Infosys Ltd.
- The option type is put. This means that you are expecting the share price of Infosys Ltd. to decrease.
- This option will expire on 26th August 2021 i.e. last Thursday of the month.
- The strike price is Rs 1,660. This is the price at which the put option buyer will sell Infosys shares to the put option seller.
- The underlying value is Rs 1,739.90. This is the current share price of Infosys Ltd.
- Lot size is 600 shares.
- 0.55 is the premium paid. Total premium for this contract is Rs 330 (0.55 * 600 shares)
Now that you are aware of the basics, let us understand a typical put option transaction.
[Must Watch: Watch our Detailed Video on Put Options]
How Does a Put Option Work?
A put option is a contract between the buyer and the writer. The buyer wants to sell the asset and the seller is obligated to buy. They hold opposite views on the asset. The buyer is expecting that the price of the asset will fall. While the seller is expecting the price to increase or stay flat.
Example: The market price (spot price) of Reliance Industries on 24th August 2021 is Rs 2,183. Ram expects that the share price will fall. Whereas Shyam expects the share price will rise.
So, Ram and Shyam enter into a put option contract. The strike price is decided at Rs 2,000 and the expiry is 30th September 2021. The premium paid by Ram to Shyam is Rs 50.
When will Ram i.e. put option buyer make profit? – When the current market price of the stock is less than the strike price.
Scenario 1: On expiry, spot price of Reliance Industries Ltd. is Rs 1,950.
If Ram goes to sell his stock in the market, his sale price will be Rs 1,950. But Ram has bought the right to sell at Rs 2,000 from Shyam. So, he is able to sell above the market price. The difference between the strike price and spot price is Ram’s profit.
In this case, the strike price of Rs 2,000 is greater than the spot price of Rs 1,950 and hence Ram will exercise his right.
When will the option seller make profit? – When the spot price is higher than the strike price.
Scenario 2: On expiry, spot price of Reliance Industries Ltd. is Rs 2,200.
If Ram goes to sell his stock in the market, his sale price will be Rs 2,200. So, why will he sell his stock to Shyam for Rs 2,000? So, Ram will not exercise his option and the seller will get to keep the premium.
Trading of Put Options
All option contracts in India are cash settled. In fact, the majority of options trader’s trade options premium. Very few option traders will hold options until their expiry.
The image above is a put option of Infosys Ltd. for strike price of Rs 1,720. It will expire on 30th September 2021. This option opened for trading at Rs 45 and made a high of 61.70. So, an intraday profit of 37% was readily available for intraday traders.
This is how options are traded in India. But they are settled in cash. This means that on actual expiry, shares are not transferred between the buyers and sellers. Instead the difference is settled in cash.
Let us understand this with the following example –
The spot price of Ashok Leyland Ltd on 23rd August 2021 is Rs 117.70. The put option for strike price of Rs 115 is trading at Rs 4.35. The lot size is 4,500 shares. Ram is bearish on Ashok Leyland Ltd so he buys this put option.
On expiry, let’s assume that Ashok Leyland Ltd is trading at Rs 110. In this case, Ram will sell his shares to Shyam for the higher price i.e. Rs 115 instead of selling it in the market at Rs 110.
So, Shyam will pay the difference i.e. Rs 115 – 110 = Rs 5 * 4500 = Rs 22,500
Physical transfer of shares will not take place. This settlement takes place on expiry only since Indian options are European in nature.
Watch this video to learn when to buy or sell call and put options
Let us now look at how much profit and loss is incurred by a put option buyer and seller.
Payoff for a Put Option Buyer
Consider that a stock is trading in the market at Rs 50. This is its spot price. You have bought a put option on this stock at a strike price of Rs 40. For this, you have paid a premium of Rs 5 to the put writer.
On expiry, three things can happen –
- Spot price = Rs 60
- Spot price = Rs 40
- Spot price = Rs 30
Remember, a put option buyer is in profit only when the strike price is greater than the spot price. But in the first case, the strike price of Rs 40 is less than the spot price of Rs 60. So, the put buyer will not exercise his right. His loss is limited to the premium paid i.e. Rs 5.
In the second case, spot price is equal to strike price. But remember that he has also paid a premium. So, technically he has paid Rs 45 for a stock worth Rs 40. So, he will not exercise his right.
In the third case, the market value of the stock is Rs 30. This means, strike price of Rs 40 is greater than spot price of Rs 30. This is a winning situation for the put option buyer. So, he will exercise his right.
His payoff will be as follows:
Notice the following:
- As long as the strike price is less than or equal to the spot price, the put option buyer will make a loss. But his loss is limited to Rs 5 only i.e the premium paid.
- His break-even point is reached when spot price is Rs 35. i.e. spot + premium is equal to strike price of Rs 40.
- As the stock price crosses the break-even point, his profit is unlimited.
Payoff for a Put Option Writer or Seller
The exact opposite is true for a put option seller. Let us look at this transaction from his point of view.
Notice the following:
- A put option seller makes profit as long as the spot price is equal or more than strike price.
- But his profit is limited to the premium received i.e. Rs 5.
- His break-even point is when spot + premium received is equal to strike price.
- When spot price falls below strike price, the buyer will exercise his option and the seller will have to buy it from him at a higher price. This is why his loss is unlimited.
Since the loss of a put option writer is unlimited, he is required to deposit margin with NSE before entering into a position. The buyer of the put option is not required to deposit margin money.
Let us quickly summarise the put option buyer Vs writer argument.
Put Option Buyer Vs Seller
|Put Option Buyer||Put Option Seller|
|He has the right but not obligation to sell||He has an obligation to buy if the buyer exercises his right.|
|He pays the premium||He receives the premium|
|He has a bearish view on stocks and the market.||He has a bullish or neutral view of the stock or market.|
|His profit is unlimited||His profit is limited to the premium received|
|His loss is limited to the premium paid||His loss is unlimited if the market or stock price falls.|
|He makes profit when market or stock prices fall||He makes profit when the market or stock price stays flat or rises.|
|Starts making money at break-even point||Starts losing money at break-even points|
|Margin amount is not required||Margin amount is compulsory before entering into a position as the loss is unlimited.|
The value of a put option decreases as the time to expiry approaches. This is because there is less time to profit from the contract. This brings us to an interesting concept – Intrinsic Value of a Put Option.
Intrinsic Value of a Put Option
Intrinsic value is the real value of an options contract. It is the money you would make on exercising a contract immediately. It is always a positive number for both call and put options.
Let us take an example to understand the intrinsic value of a put option.
Bank Nifty is trading at 35,124.40 as on 23rd August 2021. Suppose you expect it to fall so you buy a Bank Nifty Put option at a strike rate of Rs 34,500. You paid a premium of Rs 358.50.
As a put option buyer, your position will be as follows:
Notice the following here:
- A put option buyer will make profit when the intrinsic value is positive i.e when strike price is more than the spot price.
- Since a put option buyer pays the premium, it is an outflow and hence mentioned in negative (-).
- A put buyer starts making a loss when the strike price falls below the spot price. In this case, he will not exercise his option. So, his maximum loss is limited to the premium paid.
Now let us look at this same situation from a put option seller’s point of view.
|Put Option Writer|
- Since a put option buyer receives the premium, it is a cash inflow and shown in positive (+).
- A put option seller is obligated to buy even if he is making a loss.
- Loss for a put option seller starts when strike price is greater than spot price. His loss is unlimited.
- Profit for a put option seller starts when spot price is greater than strike price. In this situation, the put option buyer will not exercise his right. And the seller will get to keep the premium as profit.
Profit & Loss (P&L) of Put Options
You now know that the profit for a put option buyer is unlimited. But how can you determine the profits and loss of a put option?
You can use the below formula to calculate profit and loss of a put option.
In the above example, notice that as long as the strike price is equal or less than spot price, the loss for the put option buyer is limited to the premium paid.
As the spot price falls below the strike price, the put option buyer starts making (unlimited) profit.
The reverse is true for put option writer.
At this point, you should also know about the breakeven point for put options.
Break-Even Point (Put Option) = Strike Price – Premium Paid
So, in case of Bank Nifty, the break-even point would be = 34,500 – 358.50 = 34,141.50. When the spot price of Bank Nifty is 34,141.50 the put option buyer will break even.
Whereas for a put option seller, P&L = Premium – Intrinsic Value
Let us now talk about the moneyness of put options.
Moneyness of Put Options.
At any given point of time, an option can be:
- Deep in the money
- In the money (ITM)
- At the money (ATM)
- Out of money (OTM)
- Deep out of money
The simplest way to understand whether an option is ITM, ATM or OTM is to look at its intrinsic value. Higher the intrinsic value of an option, the more in the money it is. However, premium decreases as you move from deep ITM to deep OTM. Also, remember that ITM options are more expensive than OTM options.
- If the intrinsic value of an option is greater than zero (0) then the option is In the Money.
- If the intrinsic value of an option is equal to zero (0), then it is Out of Money.
- The value closest to the spot price is At the Money.
Let us understand the moneyness of put options using the option chain of Infosys Ltd.
The spot price of Infosys Ltd on 23rd August 2021 is Rs 1,715.20. The following is its option chain expiring on 30th September 2021.
|1715.2||1500||-215.2||Out of Money|
|1715.2||1720||4.8||At the Money|
|1715.2||1740||24.8||In the Money|
|1715.2||2060||344.8||Deep in the Money|
You can use the following formula to decide the moneyness of put options.
- If strike price > at the money = ITM option
- If strike price < at the money = OTM option
You can find the options chain for all stocks on www.nseindia.com. For your convenience, in the money contracts are highlighted in grey.
Investors often believe that they can make money by only buying calls. However, this is not true. Buying put options is equally lucrative and you can play around with different put option strategies which we will discuss in upcoming articles.
To learn more about options trading, watch our Chief Markets Editor, Apurva Sheth in conversation with Shubham Agarwal as they unveil the basics of options trading for beginners.
To win in options trading, you need a broker who provides hassle-free margins. This is where Samco is the perfect match. Open a FREE Demat account with Samco, the best discount broker in India.