What Is a Put Option & How It Works in Trading

Put options are a fundamental part of derivatives trading, granting the holder the right—but not the obligation—to sell a specified quantity of an asset at a pre-determined price within a set timeframe. These instruments play a crucial role in risk management and strategy execution in the stock market. In this detailed overview, we’ll explore what put options are, how they function, the terminology involved, their practical applications, risks, and how they differ from call options.

A put option is a contract that gives the option buyer the right to sell a specific underlying asset at a designated price (called the strike price) before a specified expiry date. It is one of the two main types of options—the other being a call option, which provides the right to buy.

Put options are typically used when an investor anticipates that the price of the underlying asset will fall. This right to sell can be exercised at any time before the expiration date (in American-style options) or only on the expiration date (in European-style options). In India, exchange-traded options are European-style, which means they can be exercised only on the expiry date, not before.

The main purpose of a put option is to act as a protective tool or profit opportunity in declining markets. Here are key reasons why investors use put options:

• Hedging: Protecting an existing stock position from downside risk
  

• Speculation: Profiting from an anticipated decline in an asset’s price
  

• Strategic trading: Forming part of broader options strategies like spreads, straddles, or collars
  

Put options are also valuable to portfolio managers and institutions to ensure risk-adjusted returns.

A put option works through a simple contract between a buyer and a seller:

In a put option contract, the buyer (holder) pays a premium to gain the right to sell the underlying asset at a specified strike price within a set time. Conversely, the seller (writer) receives the premium but takes on the obligation to buy the asset from the holder if the option is exercised. The buyer has the right, but not the obligation, to sell, while the seller must fulfill the contract if required.

Key terms in put option trading

Understanding some key terms helps navigate put options better:

• Strike Price: The set price at which the asset can be sold
  

• Premium: Cost of buying the option
  

• Expiry Date: Last date the option can be exercised
  

• Intrinsic Value: Difference between strike price and asset price (if favourable)
  

• Time Value: Portion of the premium attributable to time remaining until expiry
  

• Theta (Time Decay): The rate at which an option loses value as it nears expiration
  

Suppose you buy a put option for Stock A:

Strike Price = ₹500
Premium Paid = ₹20
Current Market Price = ₹500

Now if Stock A falls to ₹400 before expiry:

You exercise your right to sell at ₹500
Profit = ₹100 (difference between strike and market price)
Net Profit = ₹100 - ₹20 = ₹80 per share

If the stock remains above ₹500, the option may expire worthless, and you only lose the premium.

You should buy a put option when you expect the price of the underlying asset to decline. It allows you to sell the asset at a fixed strike price, potentially profiting from the drop. This is a common strategy for hedging against losses or speculating on bearish market trends with limited risk.

You should sell a put option when you believe the price of the underlying asset will stay the same or rise. As a seller, you earn the premium income and only need to buy the asset if the buyer exercises the option. This strategy suits bullish or neutral market views, but carries risk if the asset price falls significantly.

Advantages

• Downside protection: Put options are ideal for hedging portfolio losses. They give the right to sell an asset at a fixed price, helping limit losses during market downturns.

• Leverage: With a relatively small premium, you can control a larger position. This means higher potential returns if the asset price drops significantly, making puts cost-effective for bearish strategies.

• Defined risk: The maximum loss is limited to the premium paid, regardless of how much the asset price rises. This provides clarity and control over risk, especially in volatile markets.

Limitations

• Premium cost: In volatile markets, the cost of buying a put option—called the premium—can be quite high. This increases the break-even point and reduces potential profit unless the price drops significantly.

• Expiry constraints:  Put options have a limited lifespan. If the expected price movement doesn’t occur before the expiry date, the option may expire worthless, resulting in a total loss of the premium.

• Complexity: Trading put options requires a good understanding of market trends, volatility, and timing. Misjudging these factors can lead to losses, making it less suitable for beginners without proper knowledge or experience.
  

Put options are frequently used in the following scenarios:

• Bearish market outlook: To profit from anticipated price declines
  

• Portfolio protection: To limit losses on held stocks
  

• Event-based hedging: Around earnings reports or macro events
  

While offering strategic benefits, put options involve several risks:

• Total premium loss: If market doesn’t move as expected
  

• Liquidity risk: Hard to exit positions at a favourable price
  

• Volatility sensitivity: Changes in implied volatility affect pricing
  

• Execution risk: Requires timely and correct decisions

 

Both puts and calls are derivative instruments, but they function differently:

Table: Put vs Call Options

This table summarises the key contrasts between the two types of options.

Put options offer a versatile mechanism for hedging and speculative trading in falling markets. They provide defined risk exposure and allow strategic positioning. While they carry risks like premium loss and timing, a solid understanding of their structure and context can make them a valuable part of an investor’s toolkit.

This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.