Derivatives Trading Basics
by 5paisa Research Team Last Updated: 2022-09-14T11:05:54+05:30

Introduction

<p>The feasibility of financial investment is a trade-off between the risk associated and the return on investment. While the risk accompanied by equity instruments is relatively high, investors may choose from various available products. Among them, futures and options are the riskiest. Consequently, the probability of return (negative or positive) is the highest for such products.&nbsp;</p>

What is a put option?

The derivatives market broadly consists of futures and options. Futures and options are financial instruments that derive value from the underlying asset. The price of a futures or options contract is directly dependent on the underlying asset's price. 

Options contracts are further bifurcated into a call and put options based on the terms of the contract. 

A put option is an option contract that gives a right to the buyer to sell the underlying asset at a predetermined price on or before the expiry of a determined future date. The put option confers a right but not an obligation for the buyer to purchase the underlying security. For this right, the buyer of a put option pays a premium to the seller. 

Unlike stocks that exist indefinitely, put options expiry at the end of the contract period. It may expire worthlessly, or the trader may settle it for the remaining value. Investors actively use put options for trading and hedging. The major elements of a put option include strike price, premium and expiration date. Let's discuss the features, viability, benefits, and uses of put options. 
 

How a Put Option Works

To understand the meaning of put options, let's discuss some basic terms associated with a put contract.

  • Strike Price – Strike price or exercise price refers to the predetermined future price to purchase the put option. The buyer and seller of a put option agree to the strike price before entering into the contract. 
  • Spot Price – Spot price refers to the market price of the underlying asset in a contract. 
  • Premium – Premium is an upfront fee paid by the buyer of a put contract to the seller. The option premium is paid to the exchange and passed on to the seller. 
  • Expiration – Each put option has an expiration date. It refers to the future date for expiry or settlement of the contract. A buyer cannot exercise a put option after expiry. 
  • Margins refer to leverage for deriving maximum gains from a put contract. A buyer may purchase a put option by paying an initial margin, not the entire contract amount.

Typically, a buyer exercises the put option when the spot price is lower than the strike price. The difference between the spot and strike price signifies the profit from the option. A put option expires on maturity irrespective of whether exercised or not. 

Premium paid is a cost for an option buyer and reduces the overall gains. Most traders prefer using margin to purchase a call and put option. Capital employed reduces drastically with the use of margin trading.

Factors That Affect a Put's Price

It is important to understand the profitability of a put option before analyzing the factors that affect the price of a put. 

A put option is in-the-money if the spot price is lower than the option's strike price. The buyer of a put option profits if the option is in-the-money. Contrarily, if the spot price is higher than the strike price, then the option is out-of-the-money, and it is not favourable for the buyer of a put option. An option is at-the-money if the option's strike price is equal to the spot price of the underlying asset. 

The following factors affect the price of a put option:

Spot Price

The spot price of an option is inversely proportional to the price of a put option. With an increase in the spot price, the option becomes more out-of-the-money. If the spot price increases, then the value of the put option decreases and vice-versa. 

Volatility

Volatility refers to the fluctuation in the price of an option. The higher the volatility, the higher the risk and the option's price.

Strike Price

The price of an option increases as the option becomes in-the-money. For a put option, the put price increases with an increase in the option's strike price.

Maturity

Time to maturity denotes the period until the expiry of a put contract. The longer the time to maturity, the higher the option's price. The price of an option includes the time value of money. The time value of money reduces to zero on expiry. 

Others

Factors such as interest rates and dividends affect the price of put options. If the interest rate rises, then the price of the put option reduces. If the dividend increases, then put prices also increase. 

Alternatives to Exercising a Put Option

Usually, buyers exercise in-the-money put options, i.e., the strike price is higher than the underlying asset price. The buyer can sell the put and earn a profit. However, if the option is out-of-the-money, then it is of no use since the intrinsic value of the option is zero. 
An alternative to exercising an option is to sell it back in the market. Selling the option is the most popular and convenient way to close an option. It does not require any time or cost. The selling of an option does not entail any transfer of the underlying shares. The investors exchange the net profit or loss from the transaction.

The best time to exercise an option is when it is in-the-money. In all other cases, it is not profitable to exercise the option. Hence, selling the option in the market is ideal for at-the-money and out-of-the-money options.   

Example of a Put Option

The buyer of a put option has a bearish outlook and profits with a fall in the underlying asset price. 

Suppose you hold the shares of XYZ Ltd and expect a change in regulations that will affect the company's profitability. The current market price of XYZ Ltd is Rs. 1000, and you expect a price fall shortly. To benefit from the expected price reduction, you purchase a put option from XYZ Ltd at a strike price of Rs. 950.
 
The market-determined premium to purchase the put option is Rs. 10 per share. The lot size of the put option is 500 shares. Thus, the premium to purchase one lot of XYZ Ltd is Rs. 5,000 (Rs. 10 per share * 500 shares). Premium is an upfront fee paid at the time of entering the contract. 

The put option expires within 90 days, and you can exercise the option any time before or on expiry. You may exercise the put option anytime on or before its expiry. The profit from a put option is as below:

[(Strike Price – Spot Price) * Number of Shares] – Premium Paid 

Let's evaluate the various options available to you at different price levels of XYZ Ltd. 

 

Case I: The price of XYZ Ltd falls to Rs. 900 per share
The buyer of the put benefits from a reduction in the spot price of the underlying security. In this case, the spot price of XYZ Ltd is Rs. 900 per share, whereas the strike price is Rs. 950 per share. You can exercise the put option and sell one lot of XYZ Ltd at a predetermined price of Rs. 950 per share versus the current market price of Rs. 900 per share. 

The profit from the trade is the difference between the strike and the spot price. Additionally, the premium paid is an upfront cost to the buyer and reduces the overall gain. 
In this case, the overall profit from the trade is: 

Rs. 25,000 (Rs. 50 per share * 500 shares) – Rs. 5,000 = Rs. 20,000
You may realize the gain by exercising the option or selling it in the market.

 

Case II: The price of XYZ Ltd rises to Rs. 1050 per share
The buyer of a put loses with an increase in the spot price of the underlying security. In this case, the spot price of XYZ Ltd is Rs. 1050 per share, whereas the strike price is Rs. 950 per share. The put option expires worthless. You can sell the share at the current market price of Rs. 1050 per share versus the pre-determined price of Rs. 950 per share.

Thus, the premium paid is a loss to the buyer of the put option. In this case, you incur a loss of Rs. 5,000. The loss for the buyer of a put option is limited.  

 

Case III: The price of XYZ Ltd reduces to Rs. 940 per share
Similar to Case I, the spot price of XYZ Ltd is Rs. 940 per share, whereas the strike price is Rs. 950 per share. You exercise the put option and sell one lot of XYZ Ltd at a predetermined price of Rs. 950 per share versus the current market price of Rs. 940 per share. 

In this case, the overall profit from the trade is: 
Rs. 5,000 (Rs. 10 per share * 500 shares) – Rs. 5,000 = NIL

Thus, Rs. 940 is the break-even point of the contract. You will neither earn a profit nor incur a loss if the spot price of the underlying security is Rs. 940 per share. 

Why sell a put option?

Purchasing a put option is one leg of an option contract. Various traders even sell put options to benefit from the underlying asset's price movement. The payoff for sellers of a put option is the opposite of those for the buyers. Sellers of a put option expect the underlying price to rise or stay flat. 

For example, you sell a put option of ABC Ltd at the strike price of Rs. 1000 per share and a premium of Rs. 10 per share. The lot size of the contract is 1000 shares. Suppose the price of ABC Ltd on expiry is Rs. 1050 per share, then the buyer will not exercise the put option. However, the seller of the put option profits to the extent of the premium paid. In this case, the seller of the put option gains Rs. 10,000 (Rs. 10 per share * 1000 shares). 

For the seller of a put option, the maximum profit from the trade is the premium amount. The maximum loss potential is the strike price of the option less the premium received. Therefore, the profit potential is wider for put option buyers.

The primary advantage of selling puts is that the seller receives upfront cash. The seller may not have to purchase the stock at the strike price if the option expires worthless. Selling a put seems like a low-risk proposition, but if the stock plummets, the seller must purchase the underlying asset at a much higher strike price.  

Advantages of buying put options

The definition of a put option is a financial instrument that confers a right to sell the underlying asset at a predetermined price on or before a future date. A put option allows the buyer to lock in the selling price of the underlying asset for a fixed period.

The benefits of buying put options are as below:

Less Investment, Higher Profits 
Put options allow traders to take a position for a marginal upfront fee. The buyer pays a premium before entering into a contract instead of the entire value of shares. Put option contracts allow an investor to use leverage for maximum cost efficiency. 

For example, you purchase a RIL put option for a strike price of Rs. 1500 with a lot size of 100 shares. To buy the option, you pay a premium of Rs. 15000 (Rs. 150 per share * 100 shares). The value of RIL reduces to Rs. 1200 within the expiry period. Therefore, you earn Rs. 30000 (Rs. 300 per share * 100 shares). The net profit after deducting the premium paid is Rs. 15,000. 

Alternatively, if you trade in shares for the period, the capital commitment required is Rs. 150,000 (100 shares * Rs. 1500 per share).  

Furthermore, the buyer of options needs to maintain an initial and maintenance margin with the broker through the contract period. However, the buyer may use other financial instruments as collateral and restrict the capital commitment for the trade. 

Hedging
Hedging refers to the mitigating risk associated with a trade. For example, you have an overall equity portfolio of Rs. 5 Lakhs. You want to reduce risk due to market volatility and purchase NIFTY put options. Even if the market goes down, index put options can set off the loss due to price fall. 

Put options provide investors with ample opportunities to profit from stock price volatility. Various option trading strategies involve using spot markets, call, and put options to maximize the profit potential from a trade. 

Put options vs call options

A call option is the opposite of a put option. It allows the buyer the right to purchase the underlying asset at a predetermined price on or before a future date. The call option buyer has a right but no obligation to buy at a predetermined strike price. 

Distinctive characteristics between call and put options are as below:
1. A call option is profitable if the value of the underlying asset rises but the buyer of a put option gains if the value of the underlying asset reduces. 
2. The potential profit from a call option is unlimited since there is no cap on price rise. However, the profit potential for a put option is limited. 
3. A call option is in-the-money if the spot price exceeds the strike price. However, a put option is the in-the-money if the strike is more than the spot price. 
 

The Bottom Line

The risk associated with put options is relatively high. Investors can use puts such that it limits the risk and allows the potential for profit with a rise and fall in the underlying price. 

FAQs:

Q1. How do you profit on a put option?
Ans. You can profit from a put option if the underlying asset's price is less than the strike price on or before the expiry date. Thus, you will sell the underlying asset above the market price. 

Q2. What to do after you buy a put option?
Ans. You may exercise the option on expiry and sell the stock on expiry. Alternatively, you can sell the put to another buyer before expiry at market price. 

Q3. What happens if I don't sell my put option?
Ans. In-the-money options: The exchange automatically exercises options that are in-the-money on expiry. 
Out-of-the-money options: These options will expire worthlessly. Premium paid is a cost for the buyer.

Open Free Demat Account

& get benefits worth 2100*

Resend OTP
Please Enter OTP
  • Have Promo code?
  • Use code ACT2100
Enter Promo code
Account belongs to

By proceeding, you agree to the T&C.