What Is Put Option in Share Market

Introduction

Did you know the stock market isn't just about buying low and selling high? Sophisticated tools like options can help you hedge risks or speculate. One such tool is the "put option." For investors, understanding what a put option is in the share market can open new avenues for strategy and protection against losses. Let’s dive in and demystify our options, starting from the basics.

What Is A Put Option?

A put option is a financial contract that gives the holder the right, but not the obligation, to sell a specific amount of an underlying asset (like a stock) at a predetermined price within a set time period. If you buy a put option, you are betting that the underlying asset's price will go down.

This way, you can sell the asset at the higher, agreed-upon price even if its market price falls. If the price doesn't drop, you only lose the premium paid for the option.

Example of a Put Option

Rahul, a seasoned investor, holds 100 shares of XYZ Ltd., each currently valued at ₹2,500. Anticipating a potential dip in the stock price over the coming month, he takes proactive measures to safeguard his investment. To do so, he purchases a put option with a strike price of ₹2,400, costing ₹50 per share and expiring in one month.

As Rahul had feared, the stock price dropped to ₹2,200. Thanks to the put option, he has the right to sell his shares at ₹2,400, thereby limiting his loss to ₹150 per share (including the premium paid for the option). Without this strategic move, his loss would have been a steeper ₹300 per share, highlighting the importance of risk management in investment.

How A Put Option Works?

To understand how a put option works, let's break it down in a simple and detailed way:

Step 1: Purchase

When someone buys a put option, they essentially buy the right to sell a specific asset (like a stock) at a predetermined price. This right is bought from an options exchange or a broker.

Step 2: Premium

To acquire this right, they pay a premium fee to the seller (writer) of the put option. Think of this premium as the cost of an insurance policy—a small amount paid upfront.

Step 3: Expiration Date

Every put option comes with an expiration date. This is the deadline by which the buyer must decide whether to use the option or let it expire. After this date, the option is no longer valid.

Step 4: Strike Price

The strike price is the fixed price at which they can sell the underlying asset. It's predetermined when the put option is bought. For example, if the strike price is ₹2,400, the buyer has the right to sell the asset for ₹2,400, regardless of its current market price.

Step 5: Exercising The Option

The key part of a put option is deciding when to exercise it. If the asset's market price falls below the strike price, the buyer can exercise the option. This means they can sell the asset at the higher strike price (₹2400 in our example), even though the market price is lower.

Factors Affecting A Put’s Price

Several factors influence the price of a put option:

1. Stock price: If the stock price falls, the put option becomes more valuable.

2. Strike price: The higher the strike price relative to the stock price, the more valuable the put option.

3. Time to expiration: More time until expiration usually means a higher premium, as there is more time for the stock price to drop.

4. Volatility: Higher market volatility increases the put option's price, as the likelihood of the stock price dropping is higher.

5. Interest rates: Changes in interest rates can impact the option's price, although this is typically a minor factor compared to others.

Alternative To Exercising a Put Option

Instead of exercising the put option, you can:

1. Sell the option:

If the value of the put option has gone up, you can sell it to someone else. For example, if you bought the option for ₹50 and now it's worth ₹100, you can sell it and pocket the ₹50 profit without selling any actual stocks.

2. Offsetting position:

You can take an opposite position to reduce your risk. For example, if you have a put option (which profits if the stock price goes down), you might buy a call option (which profits if the stock price goes up). This way, you can balance your risk, and potential losses in one position could be offset by gains in the other.

3. Let it expire:

If the stock price is higher than the strike price (the price you have the right to sell at), it might make sense to do nothing and let the option expire. This is often a good choice if the option was not very expensive. By letting it expire, you avoid the hassle of selling your stock at a loss and can simply move on to other investment opportunities.

These strategies can help you manage your investments more flexibly and possibly save you money compared to directly exercising the put option.