Skill Takeaways: What you will learn in this chapter
- What are put options?
- How do you put them to use?
- Benefits of put option
- Naked and covered puts
When you anticipate weakness in the stock market in general or in any particular stock, the best and the smartest thing to do is to sell that stock and buy it back at lower levels subsequently. Suppose you hold shares of A Ltd, the price of which you expect to go down from the current level of say, Rs 100, to Rs 80, in the coming days. So, the natural reaction would be to sell that stock now and buy it again when it reaches the level of Rs 80. This strategy helps you to bring down the cost of the stock and also stay invested in it for the long term. But this you can do only if you own that particular stock.
However, options contracts provide you with an opportunity to sell a stock, including indices, without owning them. This can be done by simply buying a put option. Just as buying a call option gives you a right to buy an underlying asset or contract at a predetermined price at a future date, buying a put option too gives the right — but this right is to sell — an underlying asset or contract at a predetermined price at a future date. But remember, both call and put gives you the right and not the obligation to buy/sell the underlying.
Suppose your analysis shows that the Infosys stock has turned weak, and you expect its price to correct in the coming days. If you already own that stock, you could sell that stock on, say, August 10, 2022 (when you made the analysis) and buy it back later when the stock price corrects. But if you don’t have that stock in your portfolio and you are confident in your analysis, you can buy a put option of Infosys and take advantage of the correction in its stock price. Suppose you buy Infy September 2022 PE 1,500 out-of-the-money (OTM) option for Rs 20 (lot size 600) on August 10 by investing just Rs 12,000. Thereafter, the stock price continued to correct as anticipated by you and went below Rs 1,500 on August 29. The option premium for 1,500 PE, too, has gone up to Rs 65, helping you earn a clean profit of Rs 45, i.e., Rs 65-Rs 20. Thus, you earned a profit of Rs 27,000 on an investment of Rs 12,000. On the other hand, if you had sold Futures of the Infy stock, your investment would have been much higher, which would have brought down your return on investment considerably. In the case of Futures, your investment would have been higher because of higher margin requirements by the exchanges. Also, in the case of Futures, your risk of loss would have been much higher, whereas, in the case of put options, your loss is restricted to the premium you have paid while buying the PE.
Call Option Vs Put Option
|Call Option||Put Option|
|Buying CE is part of strategy in a rising market||Buying PE is part of strategy in a falling market|
|Buying CE gives you the right to buy the underlying||Buying PE gives you the right to sell the underlying|
|Option seller faces unlimited risk||Option seller faces limited risk as price of underlying cannot go below zero|
|Option buyer makes profit only when the price of underlying moves above strike price||Option buyer makes profit only when the price of underlying goes below strike price|
|Call buyer gets only the right and not the obligation||Put buyer gets only the right and not the obligation|
|CE buyer needs to pay premium||PE buyer needs to pay premium|
|CE buyer’s right lapses after expiry date||PE buyer’s right lapses after expiry date|
Put Option as a hedging tool
Put option is not necessarily always bought for speculative purposes; it can be bought by a long-term investor, too, to protect the value of his stocks in the portfolio. In the above case, if the investor owns 100 Infosys shares and he expects the price to correct in the coming days, one of the options would be to sell the 100 shares and buy it back at lower levels whenever the stock price corrects. However, some long-term investors do not like to keep on selling and buying shares as it will have tax implications too. In such cases, the investor can buy Put Options and, thus, participate in the price correction. If the investor had bought a put option as above, he would have earned Rs 27,000, whereas by selling a stock at Rs 1,600 and re-entering at Rs 1,500, he would have earned a profit of only Rs 10,000. Also, he might have lost the advantage of long-term capital gains.
Thus, in a put option contract, the buyer makes money when the price of the underlying goes down. In the above case, the price of Infosys went down from Rs 1,600 to below Rs 1,500, and at the same time, the option premium went up from Rs 20 to Rs 65. The put option buyer makes money simply by closing his contract.
Put Option Writer
You can buy a Put Option only when there is somebody (technically known as a counterparty) who is ready to sell it. These option sellers are usually called Option Writers, who earn from the option premiums. Put option writers earn when the stock/index price goes up against the put buyer’s view. The option writer also carries the risk of losing money if the stock price doesn’t move in the direction he had expected. But, unlike a call option seller who carries unlimited risk, the put option writer’s loss is limited (but not pre-determined). In the above example, the maximum correction in the stock price will be up to zero, whereas on the upper side, it is unlimited (theoretically). It also gives an opportunity, sometimes, to own an underlying below-the-market price.
Naked put option
A naked put option is an option contract where the option writer sells the put option without holding a short position in the underlying asset. Such a type of transaction is also called uncovered or short put. This is a bullish strategy where the option writer profits from the option premium paid by the put buyer. The premium amount will be the maximum profit a put writer can earn. While a short put writer earns a profit when the price of the underlying stock goes up, the buyer of a short put option makes money only when the price of the underlying goes down.
Things to remember
- Put option is not necessarily always bought for speculative purposes; it can be bought by a long-term investor to protect the value of his stocks in the portfolio.
- In a put option contract, the buyer makes money when the price of the underlying falls.
- Unlike a call option seller who carries unlimited risk, the put option writer’s loss is limited (but not pre-determined).
- In a naked put option, the option writer sells the put option without holding a short position in the underlying asset. Such type of transaction is also called uncovered or short put.