Put Options: Meaning, Types, and How They Work

Investors in India have various investment opportunities, and one of the most prominent is trading in stocks. In fact, the number of Demat accounts skyrocketed from 36 million in March 2020 to 160 million by June 2024, clearly indicating the growing interest in stock market investments. 

Among the many tools available to traders, options trading stands out. It offers two key strategies: call and put options. 

This article will deal with put options—what they are, their types, and how they work. So, read on until the end to explore everything you need about put options!

What Is A Put Option?

A put option is a financial contract that gives you the right, though not the obligation, to sell a security at a specific price. This price is known as the strike price. You can sell the security before or on a set date with the use of the Put Option. 

Moreover, it allows you to benefit if the security’s price drops, as you can sell it at a higher strike price. While stocks are commonly used with put options, they can also be applied to commodities, futures, and currencies.

How Put Options Work in the Stock Market?

In the stock market, a put option gains value when the underlying stock price falls. If the stock price rises, the put option loses value. Investors use put options to hedge against or speculate on a stock's decline.

A common strategy is a protective put, which acts like insurance. You buy a put option to protect against losses on your stock. If the stock price drops, you can sell it at the strike price, minimising your losses.

If you don’t own the stock and exercise a put option, it creates a short position, allowing you to profit from a stock’s decline.

Advantages of Using Put Options

Put options remain a favourite among other types of options as they offer more choices and strategies to make and invest money through them. There are some reasons why you should use Put Option in trading:

1. Hedging

Put options protect your investments by limiting losses if the stock price drops, acting as insurance for your portfolio.

2. Profit from Declines

You can benefit from a falling stock price without owning the stock by exercising a put option.

3. Limited Risk

Buying a put option limits your risk to the premium paid, unlike short selling, where losses can be unlimited.

4. Flexibility

Put options allow you to choose when to sell, providing more control over your investment strategy, especially with American options.

Risks of Using Put Options

While put options offer advantages, they also carry certain risks that you should be aware of:

1. Limited Lifespan

Put options have an expiration date, meaning your profit opportunity is time-bound. If the stock doesn’t fall in price by expiration, the option becomes worthless, and you lose the premium paid.

2. Premium Loss

The premium is the price paid to purchase the put option. It is non-refundable. The premium is lost if the market doesn’t move as expected, even if the option is not exercised.

3. Market Timing Risk

Predicting when the stock price will drop can be difficult. Poor timing may lead to missed opportunities, as the option may expire before the stock reaches the anticipated price drop.

Examples of Put Option Strategies

Here are some of the most common put option strategies:

Protective puts

Protective puts are also known as married puts. They allow you to safeguard the securities you purchased from price decline. In this strategy, you hedge your options against declining prices.

Bull put spread

If you speculate that there would be a price increase in the underlying assets, then you may opt for a bull put spread strategy. In this strategy, you purchase a put option by paying a premium amount and then sell the higher price. 

Bear put spread 

If you think the underlying stock's price decline will be moderate or large, you may choose a bear put spread strategy. This strategy includes selling put options at a lower strike price with similar expiration dates as the same when you purchased them.

Conclusion

Many perceive option trade as highly risky investments, but this view can shift with proper understanding and strategy. Now, you must’ve understood that utilising put options thoughtfully allows you to manage risk effectively and capitalise on market movements, whether prices rise or fall. 

Moreover, strategies like protective puts, bull spreads, and bear spreads help limit potential losses while seizing profit opportunities. So, remember to use Options strategies wisely!

FAQs

Q1. What are the different types of put options?

There are two main types of put options: American and European. American put options can be exercised anytime before expiration. Meanwhile, European put options can only be exercised on the expiration date.

Q2. What is a put option, and how does it work?

A put option grants you the right to sell a security at a predetermined price before a specific expiration date, allowing you to profit if the asset's price decreases.

Q3. How do you make money on puts?

You can profit from put options when the underlying stock price falls below the strike price, allowing you to sell at the higher strike price or close the position for profit.

Q4. How do you calculate the option profit?

To calculate profit, use the formula:

Profit = (Strike Price - Stock Price at Expiration - Premium Paid) × Lot size