A striking feature of a put option is that it allows you to protect your stocks portfolio from the downside without you having to sell your portfolio. In normal circumstances, if an investor expects the stockmarket to go down, he would sell his portfolio, wait for the market to bottom out and then buy again. If the market doesn’t move down as anticipated, he undergoes the selling exercise unnecessarily. A put option, instead, provides a hedge on the downside.
HOW PUTS WORK
When you buy a put option, you have the right to sell a stock or an index at a particular price (called the strike price). Suppose, you buy a put option on Nifty at a strike price of 4,800. If the Nifty falls below 4,800, your put option begins to pay you back. The more it falls, the higher the pay- back
For this privilege, investors have to pay a fee—’premium’—to the option seller. Why would somebody want to sell a put option? The seller anticipates the price of the stock to rise and earn a profit by writing a put option, If at a future date, the price of the stock is higher than the strike price, the buyer wouldn’t sell at the strike price and the seller gets to keep the premium.
TO BUY A PUT OR SE IL. FUTURES
Some investors tend to sell stock or index futures. In the domestic market, you can’t sell a stock that you don’t own. But you can sell futures and settle the profit or loss on the expiry date. Instead of a premium, investors pay margins to sell futures. The margin is refundable if the price moves in your anticipated direction. How does buying a put option compare with selling futures? Suppose, you buy a put option on Nifty at 4,700 at a premium of Rs 65. If Nifty goes up to 5,000, all you lose is your premium. However, if you sell Nifty futures at, say, 4,700, and Nifty goes up to 5,000, your loss is Rs 300.
SQUARING YOUR PUT OPTION
Options traded on NSE, with underlying as indices, are of European type. This means the buyer of the option can’t exercise his option before the expiry date. This, however, doesn’t mean that he can’t liquidate his position before expiry. Suppose, an investor has bought a put option on Nifty at a strike price of 4,900 by paying a premium of Rs 65, with the contract expiring on the last Thursday of February. Say, on 20 February, Nifty is trading at 4.600, the option buyer can sell a put option for, say, Rs 295, thus not only recovering the premium, but also earning an additional sum because Nifty has come down from 4,900 to 4,600. His right to sell Nifty at 4,900, thus, becomes more lucrative.
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