What are Put Option Buying? - Learn The Basics | Espresso

The Put Option Buying

One of the most frequently used phrases among active traders in the financial market is the put option buying. Understanding its meaning and implications will help you utilise it wisely. It is used predominantly by hedgers to reduce the extent of losses.

Published on 17 March 2022

However, speculators who are well experienced and can make good predictions profit from the put option buying effectively. Here is everything you need to know about put option buying.

What is Put Options Buying?

Before we understand the put option, let us introduce the Options Contract.

An options contract in the derivatives market is a contract wherein two parties get the right, however not the obligation to purchase or sell an underlying asset at an agreed price on or before a specific future date. The act of buying the contract is called the Call Option, and the act of purchasing the contract is called the Put Option.

Therefore, a put option in the options contract will give the buyer the right, however not the obligation to sell the underlying asset such as stocks, commodities, currencies, etc., on or before the expiration date at a specified price. It can protect you against the decline in the underlying asset price beyond a certain extent.

How is a Put Option Beneficial?

A put option can help you prevent the extent of loss by deciding on the underlying asset's price. For example, if you possess an asset that is bound to face a decline in price, you can purchase a put option to sell the asset at the current price on a future date. In this way, even if the prices reduce dramatically, you will be able to sell it at the agreed price level by protecting yourself.

However, the benefit of put option buying comes at a cost. You have to pay a premium to your broker to execute the trade. Thus, you get protected from potential losses by just paying the premium, which is a small fraction of the contract value. 

Put Option Example

Let us illustrate an example to understand the Put Option. Suppose you are holding the shares of XYZ company and the current price is ₹800 per share. If you feel the company might underperform in the next quarter leading to a decline in the price, you can purchase a put option at ₹780.

If the lot size is 500 and the premium per share is ₹10, you will have to purchase the put option for ₹5000 for 500 shares. When the stock price reaches ₹780, if you exercise the put option, you will not profit but rather protect yourself from the losses. However, if you feel the prices might reduce further, say to ₹760 or ₹750, you can exercise the put option, then, to earn a considerable profit.

On the other hand, if the share price increases to ₹810 or ₹820, you can ignore the purchased put option. However, you will end up losing the premium paid, ₹5000 to purchase the put option.

Margins in the Put Option

Apart from the premium costs, the buyer and seller will have to pay an initial margin, exposure margin, and additional margins if applicable based on the contract to exercise the option.

The put option buyer will have limited liability, the premium amount. However, for the seller, the potential loss can be unlimited if the price of the underlying asset increases. And as a seller, you have to purchase the put option at the specified price. Due to this limited gain, the seller will have to pay an additional margin called the assignment margin, which is slightly higher than the other margin values.

How Can You Settle the Bought Put Option?

After buying the Put Option, there are different ways to settle it. Here is a detail about it.

1. Squaring off - In this case, if you hold a put option to sell a particular number of stocks, you can purchase another options contract to buy the same number of stocks. The difference in prices and the premiums will be the gain.
Also Read: Futures & options Stocks

2. Physical settlement - It is an option to exercise the put option anytime before or on the expiration date. You can sell the underlying asset as mentioned in the agreement.

3. Selling the put option - You will sell the put option you hold if both the previous methods do not seem profitable.

Conclusion

Put option buying refers to purchasing an options contract by which you get the right, however not the obligation to sell an underlying asset on or before the specified date at an agreed price. The purchase of the put option is based on the premium cost. In addition, you will have to pay margins while exercising the put option. Evaluate your gains based on the cost involved to best utilise the put option before deciding on its proceeds!

Chandresh Khona
Team Espresso

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