A put option is a type of options contract that gives the buyer the right, but not the obligation, to sell an underlying asset at a predetermined price, known as the strike price, on or before a specified date.
Traders buy put options when they expect the price of the underlying asset to fall. The concept of a put option is similar to paying a small amount to secure the right to sell something at a fixed price in the future.
For example, a farmer expects the price of wheat to fall after the harvest season. To protect against a price decline, the farmer pays a fee to secure the right to sell the wheat at ₹2,500 per quintal over the next few months.
This arrangement is similar to a put option:
| Farming example | Put option |
|---|---|
| Wheat | Underlying asset |
| ₹2,500 per quintal | Strike price |
| Fee paid to secure the right | Premium |
| Protection period | Expiry |
If the market price of wheat falls to ₹2,200 per quintal, the farmer can still sell it at ₹2,500, making the arrangement valuable.
If the market price rises to ₹2,700 per quintal, the farmer can sell the wheat at the higher market price and forgo the right secured earlier. The maximum loss is limited to the fee paid.
A put option works similarly. The buyer pays a premium for the right to sell an asset at a fixed price while limiting the maximum loss to the premium paid.
How do put options work?
When a trader buys a put option, they pay a premium for the right to sell the underlying asset at the strike price.
As the price of the underlying asset falls below the strike price, the value of the put option generally increases because the right to sell the asset at a higher price becomes more valuable.
The buyer can then choose to sell the option or exercise it, depending on the contract specifications.
If the price of the underlying asset remains above the strike price, the option may expire worthless. In that case, the buyer's maximum loss is limited to the premium paid.
Example
Reliance Industries is trading at ₹1,500.
A trader expects the stock price to fall and buys a put option with:
- Strike price: ₹1,450
- Premium: ₹30
The trader pays ₹30 for the right to sell Reliance at ₹1,450 until expiry.
If Reliance falls to ₹1,400, the put option is likely to become more valuable because it gives the trader the right to sell the stock at ₹1,450 while the market price is lower.
The trader can either:
- Sell the option and book a profit, or
- Exercise the option, subject to the contract specifications.
The breakeven price for this trade is:
Breakeven = Strike Price − Premium
₹1,450 − ₹30 = ₹1,420
This means the stock must fall below ₹1,420 for the trade to be profitable at expiry. If Reliance remains above ₹1,450 until expiry, the option may expire worthless, and the trader loses only the premium paid.
Why do traders buy put options?
Traders may buy put options to:
- Benefit from an expected decline in the price of an asset.
- Hedge an existing investment portfolio against falling prices.
- Gain exposure to downward price movements with a smaller upfront investment than short selling.
- Limit downside risk to the premium paid.
What are the risks of buying put options?
Some risks include:
- The option can expire worthless if the expected price move does not occur.
- Time decay can reduce the option's value as expiry approaches.
- The underlying asset may not fall enough to offset the premium paid.
- Options can be highly volatile, resulting in rapid changes in value.
While put options can provide downside exposure and portfolio protection, traders should understand factors such as premiums, breakeven prices, and time decay before trading them. To learn more, visit the Put Option Buying module on Varsity.