When an investor the right, but not the obligation, to buy or sell a stock at an agreed-upon price and date, it is known as a stock option. There are two types of options: the put option which is a bet that a stock will fall, or the call option which is a bet that the price of a stock will rise.
Option contracts known as put options are used when a stock or bond owner has the right, but not the duty, to sell or sell short a specific quantity of the underlying assets at or below a predetermined price within a predetermined time period. The striking price is the predetermined price at which the buyer of this option will be able to sell the shares if the option is exercised.
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Put options are traded on a variety of underlying assets, which include equities, currencies, bonds, commodities, futures, and indices, amongst other things. Essentially, this is a call option contract, in which the holder has the right to purchase the underlying at a predetermined price on or before the expiry date of the options contract, at his or her discretion.
How Put Options Work?
Whenever a buyer of a put option exercises his option before the expiry date, the seller of the put option has no alternative except to purchase the asset at the strike price that was initially agreed upon by both parties. The buyer of this option now anticipates that the value of the asset will fall, allowing him to acquire a greater amount of the item at a cheaper price.
A put options contract, in the case of American-style options, provides the buyer the right to sell the underlying asset at a predetermined price at any time up to the expiry date. Buyers of European-style options, on the other hand, may only exercise the option or sell the underlying on the expiry date of the option.
The payoff for Put Buyer and Put Seller:
For a certain period of time, the put buyer has the right to sell a stock at the strike price if the strike price is met. The put buyer must pay a premium in exchange for this privilege. As long as the underlying’s price remains below the strike price, the option will be valuable in terms of money and it will have intrinsic value. Alternatively, the buyer may choose to sell the option for a profit, as many put purchasers do, or they can exercise their option by selling the underlying stock.
- When an investor is pessimistic on a stock or underlying asset and believes that the price of the stock or underlying security will decline within a certain period of time, the investor engages in a long put option transaction.
- The short put or naked put strategy anticipates that the price of the underlying stock will rise or stay at the strike price, which makes it more bullish than the long put strategy, which is more bearish than the long put strategy.
- The primary goal of a short-put is to profit from the increase in the value of the underlying stock. It operates by selling a put option – particularly one that is more “out of the money” if the investor is more cautious about the stock’s performance.
- If an investor wants to create a “bear put spread,” they may do so by selling a “out of the money” put option at a lower price while concurrently purchasing a “in the money” put option at a higher price – both options having the same expiry date and number of shares.
- The protective put, sometimes known as the “married put,” is a technique that is similar to the covered call in that it enables an investor to effectively safeguard a long position in a normal stock by purchasing a put option on the company.
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When a trader purchases a put option contract for company ABC for Rs.1 (i.e. Rs.01/share for a 100 share contract) with a strike price of Rs.10 per share, the trader can sell the shares at Rs.10 before the end of the option period. If Company ABC’s share price drops to Rs.8 per share, the trader can buy the shares on the open market and sell the put option at Rs.10 per share. Taking into account the put options contract price of Rs.01/share, the trader will earn a profit of Rs.1.99 per share.
While trading any option it is important to keep in mind and evaluate the market and investors’ attitude on the individual stock, ETF, index, or commodity and thereby picking a strategy that best fits their goals. Investors often purchase put options on shares when they already own to act as a hedge against the decline in the share price.
Author: Mahek Medh
About the Author: Currently, I am in my second-year bachelor’s program and over the period of time I have realized that I enjoy learning about numbers and money, and I find topics of Finance to very interesting thus this is the domain and space where I wish to etch my long term career.