In the previous chapter, we explored call options and how they can be used to profit from an anticipated rise in the price of a stock. Now, let's delve into put options, which are essentially the flip side of call options. While a call option gives you the right to buy a stock at a certain price, a put option gives you the right to sell a stock at a certain price. This chapter will help you understand the concept of put options and how you can use them to your advantage, particularly in bearish market conditions.

What is a Put Option?

A put option is a financial contract that gives the buyer the right, but not the obligation, to sell a specific quantity of an underlying asset (such as a stock) at a predetermined price (known as the strike price) within a specified period. This contrasts with a call option, where the buyer has the right to purchase the underlying asset at the strike price.

When you buy a put option, you're essentially betting that the price of the underlying asset will decline. This can be a valuable tool in a bearish market or when you want to hedge against potential losses in your portfolio.

Still confused? To clarify, let's compare buying call options and put options:

Call Option - You buy a call option when you expect the stock price to increase. It gives you the right to buy the stock at the strike price.

Put Option - You buy a put option when you expect the stock price to decrease. It gives you the right to sell the stock at the strike price.

Both call and put options involve paying a premium to the option writer, and both can be used strategically to manage risk and speculate on market movements.

We hope this brings clarity to what are put options. Since we have already discussed the call option in detail so this won’t be tough.

Now, let us understand buying vs selling Put Options

When you buy a put option, you are purchasing the right to sell the underlying asset at a higher price if the market price drops. This can be an effective strategy if you anticipate a decline in the stock's value. Conversely, when you sell (write) a put option, you are taking on the obligation to buy the underlying asset at the strike price if the buyer decides to exercise the option. This can be profitable if the stock price remains stable or increases, as the option will likely expire worthless.

Also just as call options had certain jargons , put options too have these jargons-

Strike Price-  It is the agreed-upon price at which the underlying asset can be sold by the buyer of the put option.

Underlying Price - It is  the current market price of the underlying asset.

Option Premium - It is the cost of purchasing the put option, paid by the buyer to the seller (writer) of the option.

Option Expiry-  It is the date by which the option must be exercised.

Exercising the Option-  It is the act of invoking the right to sell the underlying asset at the strike price.

Let’s take a Practical Example with a Real Stock to bring better understanding of put options

Let's use a well-known Indian stock, Tata Motors, to illustrate how put options work. Suppose Tata Motors is currently trading at Rs. 920, but you anticipate that the stock price will decline due to expected weak quarterly earnings. You decide to buy a put option with a strike price of Rs. 900, expiring at the end of the month. Let's assume the premium for this option is Rs. 20 per share.

Now , there can be three scenarios just like the call option scenarios

Scenario 1: Price Falls to Rs. 850

If Tata Motors' share price drops to Rs. 850 by the expiry date, you can exercise your put option to sell the shares at Rs. 900. Since you bought the option, you are entitled to sell at the higher strike price, securing a profit. Here’s the breakdown:

Strike Price Rs- 900

Market Price -Rs. 850

Profit per Share - Rs. 50 (Rs. 900 - Rs. 850)

Total Profit would be 30 rupees ( 50-20 ,which is the premium) per share owned .

In this scenario, buying the put option was a successful strategy, as the stock price fell as anticipated.

Scenario 2: Price Stays at Rs. 900

If Tata Motors' share price remains at Rs. 900, your put option would expire worthless. There’s no benefit to selling the stock at Rs. 900  and also pay the premium fee when you can sell it directly  for Rs. 900  in the market. The loss here is limited to the premium you paid for the option.

Strike Price - Rs. 900

Market Price - Rs. 900

Loss - The premium paid for the put option i.e 20 Rs

While you lose the premium, this is a much smaller loss compared to holding the stock whose value does not decline and could increase anytime.

Scenario 3: Price Rises to Rs. 950

If Tata Motors' share price rises to Rs. 950, your put option would again expire worthless. You wouldn't sell at Rs. 900 when the market price is higher at Rs. 950. The loss here is, once again, limited to the premium paid for the option.

Strike Price - Rs 900

Market Price - Rs. 950

Loss- The premium paid for the put option i.e 20 Rs.

You will lose only the premium paid as you had bet that the stock price would fell but it didn’t.

Now , let’s understand the Perspectives of Put Buyer vs. Put Writer

Put Buyer’s Perspective

As a buyer of a put option, your objective is to profit from a decline in the underlying asset's price. You pay a premium for this right, and your potential loss is limited to this premium. The potential profit, however, can be substantial if the asset’s price falls significantly below the strike price.

Writer’s/seller’s  Perspective

As a writer (seller) of a put option, you receive the premium from the buyer. Your obligation is to buy the underlying asset at the strike price if the buyer exercises the option. Your maximum profit is limited to the premium received, but your potential loss can be significant if the asset’s price falls sharply. Writers often engage in this strategy when they believe the asset’s price will remain stable or rise.

Summarising the Jargons with Tata Motors Example

Strike Price - The price at which the asset can be sold (for put options). In this example, Rs. 900.

Underlying Price - The current market price of the asset. Tata Motors is trading at Rs. 920

Option Premium- The cost of purchasing the option , in this example Rs 20.

Option Expiry-  The last date of the month when the option can be exercised.

Exercising the Option - Selling the asset at the strike price.

Conclusion

Put options provide a versatile tool for investors to hedge against potential declines in stock prices or to profit from anticipated bearish movements. By understanding the mechanics of put options and how they compare to call options, you can enhance your trading strategies and manage your investment risks more effectively.

In this chapter, we used Tata Motors as an example to illustrate how put options work in different scenarios. By considering both the buyer’s and writer’s perspectives, we gained a comprehensive view of the potential benefits and risks associated with trading put options.

In the next chapter, we will explore payoff graphs from buyer and seller perspective of both call and put options.