What is a put option and how is it used in practice?

An option can be of two broad types: call option and put option. While the call option is the right to buy a stock or an index, the put option is the right to sell the stock or the index.

Oct 27, 2018 08:10 IST India Infoline News Service

Put and Call option
There are two parties to every option: the buyer and the seller. The buyer of an option has the right without the obligation and the seller has the obligation without the right. Since the buyer of the option has the right without obligation, he has to pay a price for that right called the option price or the option premium. It is this option price that is traded in the markets.
 
An option can be of two broad types: call option and put option. While the call option is the right to buy a stock or an index, the put option is the right to sell the stock or the index.
 
Using put options in practice?
 
You sell a stock when you believe that the upside in price is limited or when you believe that the stock is going to correct. The idea is that you can free up capital and deploy it elsewhere. Instead of selling the stock, you can also buy a put option.
 
A put option is a right to sell, which becomes profitable when the price of the stock declines. When you buy a put option, you pay a price for getting the right to sell.
 
Let us look at the four scenarios where the put option is used in practice.
 
Scenario 1: You want to play on the bearishness of a stock
 
We have seen NBFCs becoming weak in the last few weeks after the IL&FS default. Now, if a trader wants to play this risk to make profits with limited risk, then he can buy a put option.
 
Check the table below to see how it works:
Stock Name CMP Stock Price (at expiry) Put Option Strike Price Option Price Profit Earned
NBFC A Ltd. Rs100 Rs80 Rs90 Rs10 ( Rs10 Time Value) Rs5 * lot size

Consider the above scenario, where NBFC A is trading at Rs100 in the futures market. The trader expects the stock to correct significantly in the current series and purchases a put option of strike price Rs90 by paying a premium of Rs10 (time value). The trader’s analysis turns positive and the stock corrects to Rs80 by the end of the series, resulting in a profit of Rs5 (multiplied by lot size). Through this example, we see how a trader can play on the bearishness of a stock by purchasing put options.
 
Scenario 2: Forget price, just play on volatility
 
Let us say you are not sure if the price of NBFC B in the above illustration will go down. However, you are certain that due to the IL&FS fiasco, the markets will see increased volatility and so will NBFC stocks. In this case, you can play the higher volatility with options. Higher volatility is positive for the value of put options (in fact for all options).
 
Assuming that the price of NBFC B does not move in the above case, but the volatility does go up sharply, the price of the put option can still rise and result in profits. The unique thing about a put option is that it benefits from volatility. This is where put options fit in with volatility.
 
Scenario 3: You want to book profits, but don’t want to dispose the stock
Source: NSE

The above is a snapshot of the October Reliance 1,100 put option (right to sell at 1,100). Let us assume that an investor had bought the stock at Rs700 and is sitting on tidy profits. He wants to play the small corrections in the stock but does not want to close his position in cash. Currently, the market price is Rs1,155 and the 1,100 put option is available at Rs9.40. He can buy this put option; if the price of RIL comes down, he can book profits in the put option. Effectively, he keeps monetizing part of his profits on a regular basis.
 
Scenario 4: Hedging your downside risk
 
This is, by far, the most important reason why traders and even investors use put options. The stock price of SBI is currently at Rs260 and you just bought 3,000 shares (lot size). You have also hedged it by buying a SBI 255 Put at Rs3. Now, check the table below:
Assumed SBI Price
(on expiry)
Profit / Loss on stock Profit / Loss on Put Total Profit / Loss * (lot size) Total Gains/Losses
Rs230 Rs(-)30 Rs(+)22 Rs(-)8*3,000 Rs(-)24,000
Rs240 Rs(-)20 Rs(+)12 Rs(-)8*3,000 Rs(-)24,000
Rs250 Rs(-)10 Rs(+)2 Rs(-)8*3,000 Rs(-)24,000
Rs260 Rs0 Rs(-)3 Rs(-)3*3,000 Rs(-)9,000
Rs270 Rs(+)10 Rs(-)3 Rs(+)7*3,000 Rs(+)21,000
Rs280 Rs(+)20 Rs(-)3 Rs(+)17*3,000 Rs(+)51,000

Irrespective of how low SBI goes, you limit your risk to Rs24,000, i.e. the maximum loss you will incur on this transaction. Thus, put options help you effectively hedge your positions and limit your downside risks.
 

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