5.1 – Getting the orientation right
I hope you’ve finished thinking about the call option’s realities from both the sellers’ and buyers’ points of view. If you are familiar with call options, it will be quite simple for you to grasp “put options.” From the standpoint of the buyer, the only difference between a put option and a call option is that the put option buyer should have a negative opinion of the markets as opposed to an optimistic view.
The purchaser of the put option is placing a wager that the stock price will decline (by the time expiry approaches). He, therefore, gets into a Put Option arrangement in order to profit from this viewpoint.
No matter where the underlying stock is trading, the buyer of a put option can purchase the right to sell a stock at a price (the striking price) under a put option agreement.
Keep in mind this generalization: Since the seller of the option expects the exact opposite of what the buyer does, there is a market. A market cannot exist if everyone has the same expectations. Therefore, the put option seller would anticipate a rise in the market (or a flattening of the stock) if the put option buyer anticipates a decline by expiration.
At a set price (the strike price), a put option buyer purchases the put option writer’s right to sell the underlying. This indicates that if the “put option buyer” is selling the put option seller, he will have to buy at expiration. Keep in mind that the put option seller is actually selling the put option buyer a right to “sell” the underlying to the “put option seller” at the time of expiration at the time of the agreement.
Confusing? Consider the “Put Option” as a straightforward agreement between two parties to conduct a transaction based on the price of an underlying –
- The parties involved in a contract are referred to as the “contract buyer” and the “contract seller,” respectively.
- The contract buyer invests money and purchases a right for himself.
- The contract seller accepts the premium and commits to the deal.
- On the day of expiration, the contract buyer will choose whether or not to exercise his right.
- The contract seller is bound to purchase the underlying from the contract buyer if the contract buyer decides to exercise his right and sells the underlying (which may be a stock) at the agreed-upon price (the striking price).
- Since the contract the buyer holds allows him to sell the underlying at a much higher price to the contract seller when the same underlying is trading at a lower price in the open market, it stands to reason that the contract buyer will only exercise his right if the underlying price is trading below the strike price.
Still perplexing? Do not be alarmed; an example will be used to help you better comprehend this.
Take into account the following scenario between the Contract seller and the Contract buyer:
- Consider that Reliance Industries is currently trading at Rs. 850.
- The contract buyer pays the contract seller Rs. 850 for the opportunity to purchase Reliance when it expires.
- The contract buyer must pay a premium to the contract seller in order to secure this entitlement.
The contract seller will agree to purchase Reliance Industries shares at Rs. 850 a share in exchange for the premium, but only if the contract buyer wants him to purchase them from him.
For instance, if Reliance is trading at Rs. 820 upon expiration, the contract buyer may demand that the contract seller purchase Reliance from him for Rs. 850.
This indicates that the contract buyer can earn from selling Reliance for Rs. 850/- even if it is currently trading at Rs. 820/- on the open market.
It makes no sense for the contract buyer to exercise his right and ask the contract seller to acquire the shares from him at Rs. 850/- if Reliance is trading at Rs. 850/- or more upon expiration (let’s say Rs. 870/-). Given that he can sell it for more money on the open market, this is rather clear.
A “Put option” is a contract of this type that grants the buyer the right to sell the underlying asset when it expires.
Due to his sale of the contract buyer’s Reliance 850 Put Option, the contract seller will be required to purchase Reliance at Rs. 850.
I hope the discussion above has provided you with the necessary introduction to put options. It’s okay if you’re still unclear because as we move forward, I’m sure you’ll become more understandable. However, there are three crucial things you should know right now:
- The put option’s seller is neutral or optimistic about the underlying asset, whereas the put option’s buyer is gloomy about it.
- When the put option expires, the buyer has the opportunity to sell the underlying asset for the strike price.
- Due to receiving an upfront premium, the put option seller is required to purchase the underlying asset from the put option buyer at the strike price.
5.2 – Building a case for a Put Option buyer
Let’s construct a real-world scenario to grasp the put option better, just like we did with the call option. We will first discuss the put option from the buyer’s standpoint before comprehending the put option from the seller’s standpoint.
Here are some of my opinions regarding Bank Nifty:
- Trading for Bank Nifty is at 18417.
- A week ago Bank Nifty encountered resistance at 18550. (resistance level highlighted by a green horizontal line)
- Since there is a price action zone at this level that is evenly spaced in time, I view 18550 as resistance (for those unfamiliar with the notion of resistance, I recommend reading about it here).
The price action zone has been indicated with blue rectangle boxes.
The RBI maintained the status quo on the monetary rates on April 7th (yesterday), leaving the major central bank rates unchanged (as you may know RBI monetary policy is the most important event for Bank Nifty)
Therefore, given the technical resistance and lack of a significant fundamental trigger, banks may not be the trend in the markets this year.
Therefore, traders could choose to sell banks and purchase something else that is in demand at the moment.
I have a bearish leaning toward Bank Nifty because of these factors.
Since the market is bullish overall and just the banking sector is bearish, shorting futures may be rather dangerous.
Using an option is best in these situations, thus purchasing a Put Option on the Bank Nifty may make sense.
Keep in mind that if you purchase a put option, you profit if the underlying declines.
With this justification, I would rather purchase the 18400 Put Option, which is currently trading at a premium of Rs. 315. Remember that in order to purchase this 18400 Put option, I must pay the necessary premium (in this example, Rs. 315/-), which will be paid to the 18400 Put option seller.
The simplest way to purchase a put option is to phone your broker and ask him to do it for you in a matter of seconds. The put option can be purchased for any stock and strike. As an alternative, you can purchase it directly via a trading platform like Zerodha Pi. Later on, we will discuss the specifics of purchasing and selling options using a trading terminal.
It would be fascinating to watch the Put Option’s P&L behavior at expiration, presuming I had purchased Bank Nifty’s 18400 Put Option. We can even draw a few conclusions from this procedure regarding the P&L behavior of a Put option.
5.3 – Intrinsic Value (IV) of a Put Option
We must comprehend how to calculate a Put option’s intrinsic value before we can generalize the Put option P&L’s behavior. I’ll assume you are familiar with the idea of intrinsic value since we discussed it in the previous chapter. The intrinsic value of an option is the amount of money the buyer would be entitled to upon the expiration of the option.
A put option’s intrinsic value is calculated significantly differently than a call option’s intrinsic value. I’ll provide the call option’s intrinsic value formula here so you can see the differences.
Spot price minus strike price is the IV (call option).
A put option’s intrinsic value is –
IV (Put Option) = Spot – Strike Price
The formula we just looked at to determine an option’s intrinsic value is only applicable on the day the option expires. The intrinsic value of an option is, however, determined differently across the series. Naturally, during the expiry, we will comprehend how to determine (and the necessity of calculating) an option’s intrinsic worth. But for the time being, all that we need to know is how to calculate the intrinsic value at expiration.
5.4 – P&L behavior of the Put Option buyer
Let’s attempt to create a table that will help us determine how much money I, the buyer of Bank Nifty’s 18400 put option, would make under the various potential spot value changes of Bank Nifty (in the spot market), keeping the concept of intrinsic value of a put option at the back of our minds. Keep in mind that Rs 315 was paid as the premium for this choice. The fact that I paid Rs. 315 will not change, regardless of how the spot value increases. This is the price I paid to purchase the Bank Nifty 18400 Put Option.
Let’s examine the P&L’s behavior and make some observations (and also make a few P&L generalizations). Set your gaze at row number 8 to serve as your reference point for the conversation above.
- Buying a put option is done in order to profit from a declining price. As we can see, the profit rises as and when the spot market price falls (with reference to the strike price of 18400).
1. Generalization 1: Whenever the spot price falls below the strike price, buyers of put options benefit. In other words, only purchase a put option if you believe the underlying asset will decline.
2. The strategy begins to lose money as soon as the spot price exceeds the strike price (18400). The loss is however limited to the amount of the premium paid, in this instance Rs. 315.
- Generalization 2: When the spot price exceeds the strike price, the buyer of a put option incurs a loss. The maximum loss is nevertheless limited to the amount of the put option buyer’s premium.
Here is a common formula you can use to determine your profit and loss from a put option transaction. Keep in mind that this calculation applies to positions maintained until expiration.
Max (0, Strike Price – Spot Price) = P&L – Paid Premium
Let’s choose 2 random values to test the validity of the formula:
- 16510
- 19660
@16510 (spot below the strike, the position has to be profitable)
= Max (0, 18400 -16510)] – 315
= 1890 – 315
= + 1575
@19660 (spot above strike, the position has to be loss-making, restricted to the premium paid)
= Max (0, 18400 – 19660) – 315
= Max (0, -1260) – 315
= – 315
Clearly, both findings are in line with what was anticipated.
We also need to comprehend how a Put Option buyer calculates the breakeven point. Because we discussed breakeven points in the previous chapter, I’ll take the liberty of omitting an explanation here. Instead, I’ll just give you the formula to figure it out:
Strike Price – Premium Paid = Breakeven Point
To the Bank, It would be a neat breakeven point if
= 18400 – 315
= 18085
In accordance with this interpretation of the breakeven point, the put option should therefore be neutral at 18085. Please use the P&L formula to verify this.
= Max (0, 18400 – 18085) – 315
= Max (0, 315) – 315
= 315 – 315
=0
The outcome is unmistakably consistent with what was anticipated at the breakeven point.
Note: The intrinsic value, P&L, and breakeven point are all calculated with regard to the expiry. We have assumed throughout this module that you, as the option buyer or seller, will set up the option trade with the purpose of holding it until expiration.
However, you will soon come to the realization that you will frequently start an options transaction only to close it well before expiration. In this scenario, calculating the breakeven point may not be as important as calculating the P&L and intrinsic value, which can be done using a different formula.
Let me make two assumptions about the Bank Nifty Trade so that I can explain this more clearly. We know the trade was initiated on April 7, 2015, and it expires on April 30, 2015.
- What would the P&L be if the spot were at 17,000 on April 30th, 2015
- What would the P&L be if the spot were at 17000 on April 15th, 2015? (or for that matter any other date apart from the expiry date)
The first question has a reasonably simple answer because we can immediately use the P&L formula.
= Max (0, 18400 – 17000) – 315
= Max (0, 1400) – 315
= 1400 – 315
= 1085
Moving on to the second question, the P&L won’t be 1085 if the spot is at 17000 on any date other than the expiration date; instead, it will be greater. At the right time, we’ll go over the reasons why this will be higher, but for the moment, just remember this.
5.5 – Put option buyer’s P&L payoff
We should be able to see the generalizations we’ve made about the Put option buyers’ P&L if we connect the P&L points of the Put Option and create a line chart.
You should take note of the following from the preceding chart; keep in mind that the strike price is 18400:
- Only when the spot price exceeds the strike price does the buyer of the Put option suffer a loss (18400 and above)
- However, this loss is only as great as the premium that was paid.
- When the current price falls below the strike price, the put option buyer will profit exponentially.
- The potential rewards are limitless.
- You can see that the P&L graph simply transitions from a loss-making condition to a neutral situation at the breakeven point. Only above this level would the put option buyer begin to profit. The buyer of the put option does not profit or lose money at the breakeven point (18085).
CONCLUSION
- When you are pessimistic about the prospects of the underlying, you should buy a put option. In other words, a Put option buyer only makes money when the value of the underlying drops.
- When compared to the intrinsic value calculation of a call option, the intrinsic value computation of a put option is slightly different.
- The strike price minus spot price is IV (Put Option).
- P&L = [Max (0, Strike Price – Spot Price)] can be used to compute the profit and loss of a buyer of put options. – Paid Premium
- Strike – Premium Paid is the formula used to determine the put option buyer’s breakeven point.