What are PUT (PE) Options?

Disclaimer: Options trading is considered extremely risky, 9 out of 10 traders incur a net loss, please trade responsibly. See the SEBI circular for more details

This article assumes that you are familiar with options basic, If you are starting with options, make sure to check out our option primer.

What is a put options?

A Put option usually denoted by PE symbol is a type of option contract which allows buyer to sell his/her stocks a pre-determined price before the end of contract date (expiry).

For buyer, the contract provides option but no obligation to sell the stocks while for seller, there is an obligation to buy the shares. For providing this option, seller charges a “premium” for the option.

How does put option work?

A Put option is like an insurance for buyer that would guarantee fixed return in case the share price falls below the strike price of the option. However if the underlying share price is above strike price then, it does not make any sense for buyer to exercise this option.

Example:

Lets take example of 27th July Infosys (INFY) Put option for a strike price of 1450 which is closest strike price to current price, this is called an ATM (At The Money) strike.

So if I buy the PE option, and at the expiry date Infosys is trading at 1550, if I exercise the option, then I would need to sell 400 shares of Infosys to the seller of option at Rs 1450. This would mean I would have a take a loss of 100 per share and total loss of Rs 40,000, so it makes no sense for me to exercise this option, hence making this option worthless at expiry.

However if at expiry Infosys is trading at 1350, then if I exercise the option, the seller would have to buy 400 shares of Infosys from me at 1450 each, there by I would end up making Rs 100 profit per share.

Payoff Graph

If we plot the potential profit/loss of option as per price of underlying stock/index, we get a graph showing us the profit/loss at end of expiry. This graph is called a payoff graph.

The payoff graph for Infosys 1450 PE options looks like this. Since seller of option is charging a “premium” for the option, the payoff does not exactly start at 1450, it would be at 1450 – premium, which at the time of writing is at 39.8, this makes the breakeven to 1410.2 (1450-39.8) at which point the payoff graph turns in to profit zone, denoted by green.

If the option expires worthless then the buyer looses only the premium which would be 39.8×400 = 15920. So the loss of the buyer is capped at 15920 but the potential profit is unlimited, theoretically the price of underlying stock can reach 0, which would make the buyer profit of 1410.2*400 = 5,64,080

Selling a PUT option

In above example we looked from buyers perspective on what benefits it gives to buyer, now lets see why would someone sell a Put option.

A Put seller has an obligation to buy 400 shares of Infosys from the buyer, if he/she chooses to exercise the option, however as we saw it makes sense for option buyer to exercise the option only if the price of underlying stock is below 1450 (strike price). So if the Put seller is bullish on the underlying stock and if he/she is correct the option would expire worthless, thus earning the seller the premium.

Lets look at payoff graph from Sellers viewpoint

If the underlying price is above 1410.2 (1450-39.8) then the seller gets keep the premium which is 39.8×400 = 15920

However if the underlying stock price falls below 1410.2 then the seller would need to take losses. For seller the upside is limited to 15920 while the downside is unlimited.

How does Put premium change?

Options premium is determined by a lot of factors, but the Put option which is at or lower than underlying stock price would be more expensive than one which is far away from underlying stock price. i.e 1450PE would cost 39.8 while 1350PE cost only 5.65, 1550PE would cost 115. So the cost is directly proportional to the potential profit buyer would receive at expiry.

When to buy Put?

1. If you are bearish about the underlying stock then buying a Put option is most profitable.
2. Risk is limited to loosing the premium only, there by the capital required is limited to only premium. This makes option buying very lucrative for traders with low capital.
3. If you buy a PE of strike which is away from current price of underlying stock, it would cost you very little money and market makes a sudden and large move towards your strike price, then the premiums rise very very fast. This would generate very high returns for option buyer in short term.

When to sell Put?

1. If you are bullish about the underlying stock then selling a Put option can be good choice.
2. The premium of the option usually factors in the risk, ie. if 1550PE is exercised and current underlying is at 1450, the seller would loose 100 per share, but since the premium he/she receives is 115, the seller would still make Rs 15 per share.
3. Sellers usually combine the sale of Put option with other options to hedge risks. Example. a seller could sell a Put of 1350 and Call of 1550, this would hedge his/her position, seller stands to gain if the price stays in the range of 1350 to 1550. This is one of the most common option selling strategy called Short Strangle.

Conclusion

Put & Call options can be very useful tool for any trader buyer or seller, if used carefully. In most of the cases they can be combined with other options to form strategies based on your outlook of the market.