What Does “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 (the strike price) before a set expiry date of the agreement. To acquire this right, the holder or buyer pays a premium to the seller. Put options are often used as a hedge against a decline in the prices of the underlying asset or as a speculative bet that the prices will fall, allowing the holder to profit from the difference between the sale price at the strike price and the lower market price.
Investors buy put options when they anticipate a decrease in the price of the underlying stock. If the stock price drops below the strike price, they can exercise the option, selling the stock at the higher strike price and buying it back at the lower market price. Alternatively, if the stock price remains above the strike price by the expiration date, the put option can be sold back to the market at a profit if the price has increased. Put options play a critical role in portfolio protection during bear markets, providing a way to limit losses.
The primary components of a put option include:
Strike price: The set price at which the underlying financial instrument can be sold on or before the expiry date.
Premium: The cost of the option contract paid by the buyer to the seller.
Expiration: The pre-set settlement and expiration date of the option.
How Does “PUT” Options Work?
Put options are financial contracts that give the buyer the right, but not the obligation, to sell an asset at a specified price within a certain timeframe. Investors buy put options when they expect the asset’s price to decrease. For example, if a stock drops below the exercise price, the investor can sell it at the higher strike price, profiting from the decline. This is often used for hedging or speculative trading in the share market.
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).
Put Options Example
An investor purchases one put option contract for ₹7,000 on ABC company with an exercise price of ₹1,000. The current market price of ABC shares is ₹1,200. If the stock price drops to ₹800, the investor’s put option becomes in the money (ITM) because the exercise price is below the market price. They can sell their shares at ₹1,000, earning a profit of ₹10,000 (100 shares x ₹1,000 - ₹800). After accounting for the ₹7,000 premium paid, the net profit is ₹3,000.
Alternatively, if the stock price does not drop below the strike price of ₹1,000, the put option expires worthless. The investor would only lose the ₹7,000 premium paid for the contract. This example highlights how put options can be used strategically to hedge against potential declines or to speculate on the market’s direction.
Put Options Benefits
Risk Mitigation: For the buyer, put options act as a form of insurance. If a shareholder anticipates a decline in the price of a stock, they can purchase a put option to protect against potential losses. This is a common hedging strategy used by both institutional and individual investors.
Lower Risk Exposure: Put options allow buyers to benefit from a potential decline in stock prices without exposing themselves to the infinite risk associated with short-selling strategies. The potential losses for a put option buyer are limited to the premium paid for the option.
Speculation on Downside: Put options also enable buyers to profit from expected decreases in stock prices, providing a means to speculate on market downturns while capping losses.
Cost-Effective Insurance: The premium paid for a put option is generally lower than the cost of selling the underlying stock and buying it back at a lower price, making it a cost-effective way to hedge positions.
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.
Time to Sell a Put Option
The optimal time to sell a put option is typically 30–45 days before its expiration to take advantage of time decay. During this period, the premium received for the put option is at its peak, making it an attractive income-generating strategy. The strike price is another critical consideration—especially in a bull market, where you might choose a strike price 10–15% below the current market price. This strategy allows you to collect a premium while betting that the stock price will remain stable or rise.
Option type also plays a role; long-term equity anticipation securities (LEAPS) with more than 12 months to expiration can be sold to lock in high premiums. However, it’s important to note that selling puts can be risky, particularly in periods of high volatility, as the potential loss could be unlimited if the market moves against you.
To manage risk, consider the margin requirements and the break-even point—where the strike price minus the premium equals the minimum price at which the option remains profitable.
Selling a put option is not without its risks. The primary benefit is the upfront premium received, which is limited to the profit. Yet, if the market moves significantly against you, the losses can be substantial, possibly resulting in having to purchase the underlying stock at a lower strike price than the current market price. This necessitates a careful balance of timing, strike price selection, and market conditions to manage potential risks effectively.
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.
Time to Buy a Put Option
Buying a put option is typically advisable when an investor anticipates a decline in the price of the underlying asset. This expectation could be based on technical analysis, market news, or economic indicators suggesting a downturn. For example, during a bear market or when a company faces negative earnings reports, investors might decide to buy put options to protect their investments from further losses. The put option allows them to sell the asset at a predefined price, thereby capping potential losses if the market price continues to fall below the strike price.
Another scenario where buying a put option is beneficial is when an investor wants to hedge an existing position. For instance, if they already own shares of a company and fear that the stock price might drop, purchasing a put option allows them to lock in a sale price, thereby safeguarding their portfolio against significant declines in value. This strategic use of put options can be a cost-effective way to manage risk in the share market.
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.
Call Option
| Put Option
|
Call options are purchased if the investor feels the stock’s price will rise. | A put option is purchased if the investor feels the stock’s price will fall. |
Intrinsic value = Underlying stock’s price - Call strike price. | Intrinsic value = Put strike price - underlying stock’s price. |
This option provides the holder with the right to purchase the underlying financial instrument at the strike price with no commitment to do so. | This option provides the holder with the right to sell the underlying financial instrument at the strike price with no commitment to do so. |
Final Takeaway
Put options provide a flexible financial instrument that can be used for both risk management and speculative trading. The key takeaway is understanding the dual role they play: as a hedge against potential losses and as a tool for profit in declining markets. By allowing investors to sell an underlying asset at a predetermined price, put options can limit potential losses and protect portfolios during market downturns. However, they also offer opportunities for profit if the underlying asset's price falls, making them a valuable tool for those who believe in market volatility or downturns.
Overall, put options are a valuable addition to an investor’s toolkit, offering both protective and profit-making opportunities. Their strategic use can help in managing risk and optimizing returns in varying market conditions. Whether used to hedge existing positions or to speculate on price declines, put options provide a way to navigate the complexities of the share market effectively.