What is Put Option & How to Trade Them

Oscillating between highs and lows, indices such as Sensex and Nifty have eroded this year’s gains. The top US indices suffered losses over the first 3 quarters of 2022 as well. Even if the stock prices tend to rise over the long run, an investor’s path in the stock market may include dips, corrections, and even market collapses.

Predicting the next stock market meltdown or correction is challenging. However, what if there was a method to generate money even while the market was down? This is where put options come in as a powerful tool to make money or protect investments even in a sinking market.

What put means in the share market?

A put option meaning is an agreement that grants the holder the right, but not the obligation, to sell a financial instrument at a specified price (strike price) before a set expiry date of the agreement.

To get this right, the holder or buyer pays the seller an amount known as a premium.

Put options are used as a hedge against a decline in the prices of the underlying asset or as a speculative bet that the prices will fall and then make profits out of them eventually.

Buying a put option in share market means that a person is betting that the stock’s price will fall below the strike price by the expiration date.

These are the prime components of a put option:

1. The strike price (specified price): It is the price at which the underlying financial instrument can be sold on or before the expiry date.
2. Premium: It is the option contract’s cost that the buyer pays to the seller.
3. Expiration: The pre-set option’s settlement and expiration date.

How do put options work?

After understanding what is a put option, let us comprehend how it works.

Let us take a put option example to understand what is put in share market and the operation of put options.

For instance, assume you hold shares of ABC Company that you bought for Rs. 500 per share. After thorough research, you are worried that the stock might drop in value, so you purchase a put option with a strike price of Rs. 480.

For this contract, you must pay a premium. Now, you can exercise the option if the stock’s price falls to Rs. 480 or below.

However, if the stock price does not drop to Rs. 480 or below, you could suffer a loss, but it would only be for the premium paid, i.e., the loss in a put option is limited to the premium amount as you have the option to exercise the contract or let it be and take losses only in terms of the premium amount paid.

If the stock is trading below the strike price (i.e., Rs. 480), then the put option is “in the money” (ITM).

The put option is said to be “out of the money” or “OTM” if the price of the underlying asset rises above the strike price.

Finally, if the stock’s price is near or equal to the strike price, the put option is “at the money” (ATM).

How do I trade in options?

Investors must accurately evaluate the terms of the options contract and the market forecasts before they buy or sell a put option.

The essential components of an options trade that you must set up are as follows:

• The stock associated (i.e., underlying security) with the option. It can also be an index like NIFTY
• The option strategy is a put or a call
• The expiration date of the contract
• The strike price
• Option’s cost (i.e., premium)
• The order type is limit or market order.

Benefits of buying a put option

For the buyer, put options may act as a form of insurance. A shareholder of a certain stock feels that the price of that stock can slump soon. This is when they might buy a put option for that underlying stock to mitigate or balance out the losses they can suffer on their investment. This is a hedging technique that several institutional and individual investors follow.

By using put options, buyers can lower their risk. Like put options, a short-selling strategy can also be used to benefit from the fall in the stock’s price.

However, a short seller is exposed to infinite risk if the stock price appreciates, but a put option buyer can get away by only paying the premium amount and restricting their potential losses.

Why must one sell a put option?

You can sell a put option in the same way that you can buy one. Here, the trader expects the stock price to rise or remain stable.

The advantage of selling puts is that you get money upfront (premium) and might never have to purchase the stock at the strike price if the prices move in your direction. You will profit if the stock appreciates over the strike price. However, your gain as a put seller is restricted to the premium you have paid upfront. If the prices fall significantly then you can suffer substantial losses.

Put options vs call options

A call option can be bought by an investor who believes a stock’s price will increase. A put option could be chosen if they believe the price will decline.