For any trader navigating the intricacies of the equity markets, the terms “call” and “put options” are likely familiar but can be shrouded in complexity. Let’s unravel the basics without delving too deeply into the technicalities. In essence, an option is a right without an obligation.
In the realm of options, a call option grants the right to buy an asset, while a put option provides the right to sell an asset at a predetermined price on a future date. When it comes to put options in the stock market, it operates much like any other stock – the key distinction lies in trading the right itself.
A put option essentially signifies the right to sell an asset. Traders can either buy or sell put options. The buyer of a put option gains the right to sell a stock, and the seller of the put option bears the obligation to buy the stock if the buyer chooses to exercise. In India, in-the-money options (where the strike price is below the price of the underlying asset at expiry) are mandatorily exercised.
Now, why would a seller grant such a right to a buyer? The answer lies in the option premium. The seller of a put option earns the put option premium, while the buyer potentially profits once the cost of the put is covered.
Understanding the mechanics of a put option involves examining scenarios from both the buyer’s and seller’s perspectives. Consider the Nifty trading at 19,180, and the 19,200 put option (the right to sell Nifty at 19,200) is priced at Rs 45. As options are traded in lots, buying one lot of 75 units of Nifty incurs a cost of Rs 3,375 for the buyer. Here’s what you need to know:
The put option holds value if Nifty is below 19,200. If Nifty sits at 19,300, the put option becomes worthless to the buyer, who would then let it expire, resulting in a maximum loss of the premium paid. Conversely, for the put seller, this marks the maximum earning potential.
In reality, there are two ways to exit an option. Holding until expiry and exercising the put option if profitable is one method. However, the more common approach is trading put options during the month. For example, if the buyer acquired the put option at Rs. 45 and Nifty declines, pushing the put option price to Rs. 55, the buyer can close the position, book a profit of Rs. 10, and square off the option.
The logic is reversed when selling put options, which is riskier and often left to more sophisticated traders. Buying put options can serve as a hedge for long positions, protecting against potential losses.
However, it’s essential to be cautious about the downside risks of buying put options. They include a time decay component, where the contract loses value gradually as time progresses. While put options may seem tempting for speculation, their true power lies in efficiently hedging the risks associated with long equity positions.
