How a put option works can be better illustrated with the help of an example. Let us say investor X decides to buy a put option with the expectation of a price decline. The current price of this stock is Rs. 800, and he is predicting its price to go down up to Rs. 600. He enters a put option contract with investor Y with a strike price of Rs. 600. Let’s say an investor believes Reliance Industries’ stock, currently trading at ₹2200, will increase in value within the next month.
At $45, the trade has already made a profit, while the put buyer has just broken even. The biggest advantage for short-sellers, though, is that they have a longer time horizon for the stock to decline. While options eventually expire, a short-seller need not close out a short-sold position, as long as the brokerage account has enough capital to maintain it. 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.
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. 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. In general, you want to buy a put option when you have a bearish sentiment about a security. In other words, buy puts when you believe the stock’s price will go down. For example, if someone owns a lot of Apple, they may want to buy an Apple put so they won’t lose everything if Apple crashes.
FAQs on Put Options
- Pay 20% upfront margin of the transaction value to trade in cash market segment.
- Put and call options are financial contracts granting the right to sell (put) or buy (call) an asset at a predetermined price within a specified period.
- 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.
- The more people you have selling options for a specific stock, the lower the premium.
- Put options are one of the most commonly traded financial instruments in modern investing.
For this reason, you will start making profits only once the index level falls below 5,890 levels. Implied Volatility AdvantageAn put meaning in share market option contract’s implied volatility tells you how much it will cost. An option contract’s price tends to rise when implied volatility is high. For a put option trader, you want to sell when the price is high and buy when it’s low. It’s only conceivable when implied volatility is high but gradually declines. The value might fluctuate a lot depending on the economy, politics, and social events.
When should you buy a put option?
There are two kinds of put options – American and European – on the basis of when an option can be exercised. American options are more flexible; they allow you to settle the trade before the expiry date of the contract. Thus, index options are European options, while stock options are a kind of American options.
- These are some of the basics of call and put options for beginners.
- In this strategy, you purchase a put option by paying a premium amount and then sell the higher price.
- Buying puts offers better profit potential than short selling if the stock declines substantially.
- Put options play a critical role in portfolio protection during bear markets, providing a way to limit losses.
You would thus earn a profit of ₹10 per share once you have deducted the premium costs. Put sellers keep their businesses afloat by writing a ton of options on companies they think will appreciate. When stock prices fall, they think the fees they collect will cover the losses. Time value is the portion of the option’s premium that reflects the time remaining until expiration. The longer the time until expiration, the higher the time value, as there is more potential for the underlying asset’s price to move in the buyer’s favour. For example, suppose an investor writes a put option for 100 shares of a stock with a strike price of £50 and receives a premium of £3 per share.
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. Put options are one of the many versatile tools available to investors like you for the management of risks and expectations of market declines. Understanding how put options work, the price determinants of a put option, and some of the strategies for trading them can help you find your way around financial markets with utmost confidence.
Is Buying a Put Similar to Short Selling?
On the date of expiry, if the underlying stock’s price falls below Rs. 600, this put buyer will exercise his right. Then, the put buyer gets to sell the underlying stock at the predetermined strike price. For instance, imagine you buy a call option for 100 shares of Company A with a strike price of ₹120 per share, expiring on September 1st. This gives you the right to buy those shares for ₹120 each on September 1st, regardless of the actual market price at that time. If Company A’s stock price rises above ₹120 by September 1st, your option becomes profitable, as you can buy the shares at ₹120 and immediately sell them at the higher market price.
Example of put option trading
The risk is particularly severe when the underlying asset’s price drops sharply, as there is no limit to how much the writer could lose. Put options are one of the most commonly traded financial instruments in modern investing. These financial derivatives grant the holder the right to sell an underlying asset at a specific price, known as the strike price, within a designated period. Investors and traders often use them for hedging purposes, to protect their portfolios from potential losses or to speculate on price declines. In essence, the buyer of a put option is purchasing the right to sell the asset at the agreed-upon price, irrespective of the asset’s current market value.
Advantages of buying put options
When you buy a put option, you’re guaranteed to not lose more than the premium you paid to buy that option. You pay a small fee to the person who is willing to buy your stock. We understand that some stocks can crash drastically within a few days.
Futures Trading explained with its meaning, types, and strategies. Learn how it works and the pros and cons of trading futures contracts in the financial market. A put seller can get out of the agreement anytime by buying the same option from someone else. If the fee for the new option is lower than what they received for the old one, they pocket the difference. They would only do this if they thought the trade was going against them. The payoff diagram will help you calculate how much profit you will make from buying put options.
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. 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.
Step-by-step guide on how to buy a put option to profit from a stock price decline
Understanding the difference between put options and call options will help you know when to use one over the other. These are the popular options you’ll find when looking for financial derivatives. You may be able to benefit from a sell put strategy if you know what you are doing, and it could also be used along with other strategies.