In any market, there cannot be a buyer without there being a seller. Similarly, in the Options market, you cannot have call options without having put options. Puts are options contracts that give you the right to sell the underlying stock or index at a pre-determined price on or before a specified expiry date in the future. In this way, a put option is exactly opposite of a call option. However, they still share some similar traits. There is a major difference between a call and a put option — when you buy the two options.
The simple rule to maximize profits is that you buy at lows and sell at highs. A put option helps you fix the selling price. This indicates you are expecting a possible decline in the price of the underlying assets. So, you would rather protect yourself by paying a small premium than make losses. This is exactly the opposite for call options — which are bought in anticipation of a rise in stock markets.
Thus, put options are used when market conditions are bearish. They thus protect you against the decline of the price of a stock below a specified price. There are two kinds of put options — American and European — on the basis of when an option can be exercised. American options are more flexible; they allow you to settle the trade before the expiry date of the contract. European options can only be exercised on the day of the expiry. Thus, index options are European options, while stock options are a kind of American options.
Suppose the Nifty is currently trading at 6, levels. You feel bearish about the market and expect the Nifty to fall to around 5, levels within a month. To make the most of your view of the market, you could purchase a 1-month put option with a strike price of If the premium for this contract is Rs 10 per unit, you will have to pay up Rs 1, for the Nifty put option units x Rs 10 per unit. So, if the index remains above your strike price of 5,, you would not really benefit from selling at a lower level.
For this reason, you would chose to not exercise your option. You just lose your premium of Rs 1, However, if the index falls below 5, levels as expected to say 5, levels, you are in a position to make profits from your options contract.
You will thus choose to exercise your option and sell the index. That said, remember to take into consideration your premium costs. You will need to recover that cost too. For this reason, you will start making profits only once the index level falls below 5, levels. Put options on stocks also work the same way as call options on stocks. However, in this case, the option buyer is bearish about the price of a stock and hopes to profit from a fall in its price.
Suppose you hold ABC shares, and you expect that its quarterly results are likely to underperform analyst forecasts. This could lead to a fall in the share prices from the current Rs per share. To make the most of a fall in the price, you could buy a put option on ABC at the strike price of Rs at a market-determined premium of say Rs 10 per share. Suppose the contract lot is shares. This means, you have to pay a premium of Rs 6, shares x Rs 10 per share to purchase one put option on ABC.
Remember, stock options can be exercised before the expiry date. So you need to monitor the stock movement carefully. It could happen that the stock does fall, but gains back right before expiry. This would mean you lost the opportunity to make profits. Suppose the stock falls to Rs , you could think of exercising the put option.
For this reason, you could wait until the share price falls to at least Rs If there is an indication that the share could fall further to Rs or levels, wait until it does so.
If not, jump at the opportunity and exercise the option right away. You would thus earn a profit of Rs 10 per share once you have deducted the premium costs. However, if the stock price actually rises and not falls as you had expected, you can ignore the option. You loss would be limited to Rs 10 per share or Rs 6, Thus, the maximum loss an investor faces is the premium amount. The maximum profit is the share price minus the premium.
This is because, shares, like indexes, cannot have negative values. They can be value at 0 at worst. Whether you are a buyer or a seller, you have to pay an initial margin as well as an exposure margin. In addition to these two, additional margins are collected. These differ for buyers and sellers, who are at the opposite ends of the spectrum. As a seller or writer of a put option, your potential loss is unlimited. This is because prices can rise to any heights theoretically, and as a put option writer, you have to buy at whatever price has been specified.
For this reason, the buyer of a put option has limited liability — the premium amount, while the seller has a limited gain. Therefore, the seller of a put option has to deposit a higher margin with the exchange as security in case of an adverse movement in the price of the options sold.
This is called assignment margin. Just like the call option, the margins are levied on the put contract value in percentage terms. This amount the seller has to deposit is dictated by the exchange. Margin requirements typically rise during period of higher volatility. In the case of Stock options, you can buy an opposing contract. This means, if you hold a contract to sell stocks, you purchase a contract to buy the very same stocks.
This is called squaring off. You make a profit from the difference in prices and premiums. This is also a kind of squaring off method. You can also exercise your option anytime on or before the expiry date of the contract. This means, you will actually sell the underlying stocks as specified in the options contract agreement. For put index options, you cannot physically settle, as the index is not tangible. So, to settle index options, you can either exit your position through an offsetting trade in the market.
You can also hold your position open until the option expires. Subsequently, the clearing house settles the trade. If you decide to square off your position before the expiry of the contract, you will have to buy the same number of call options of the same underlying stock and maturity date.
If you have purchased two XYZ put options with a lot size , a strike price of Rs , and expiry month of August, you will have to buy two XYZ call options contracts with an expiry month of August. Thus, these two cancel each other.
Whatever is the difference in strike prices could be your profit or loss. You can also settle by selling the two put options contracts you hold in order to square off your position. This way, you will earn a premium on the contracts as the seller.
The difference between the premium at which you bought the put option and the premium at which you sold them will be your profit or loss.
Or, you can exercise your options on or before the expiration date. Your account will be then credited or debited for the amount. However, your maximum loss will be restricted to the premium paid. If you have sold put options and want to square off your position, you will have to buy back the same number of put options that you have written. These must be identical in terms of the underlying asset stock or index and maturity date to the ones that you have sold.
This will be based on the difference between the strike price and the closing market price of the stock or index on the day of exercise. You losses will be adjusted against the margin that you have provided to the exchange and the balance margin will be credited to your account with the broker. In this section, we understood the basics of Options contracts. In the next part, we go into details about Call options and Put options.
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