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Sunday, May 1, 2016

What Are Put Option Contracts And How To Trade In Them?

A put option is a derivative contract that gives you the right but not the obligation to sell (i.e short sell) a specified quantity of a security (a.k.a the underlying) at a pre-determined price on or before the contract expiry date. 

The pre-determined price at which the call option can be exercised is known as the option strike price. 


Option Premium. 

To buy a put option, one needs to make an upfront payment known as the Option Premium. This premium is simply the cost of buying an option contract and has to be incurred whether or not the option is ultimately exercised. This premium is payable by the buyer of the put option contract to the seller. The seller is often referred to as the option writer. 

Put options can have a particular security or a market index as the underlying. 

Note that Option Contracts are always net settled. 

How to Trade in Put Options? 

Put options give you the right (but not the obligation) to buy a particular security at the strike price. So if you have a view that the market price of a particular security will fall below the strike price on (or before) the contract expiry date (bearish view); you buy a put option by paying the option premium. 

If on the contract expiry date (assumed for the sake of simplicity; though an option can be exercised even before expiry) the market price of the security falls below the strike price, you exercise the option. Note that in the present scenario, since the strike price is above the market price; you effectively buy the same number of shares as represented by the Put Contract at the current market price and then sell them at the strike price. Since the strike price is greater than the market price, you buy low and sell high - thus making a profit. 

However, since option contracts are net settled, you need not take delivery; the difference between the Strike Price (your selling price) and the current market price (your buying price) will represent your gain. Of course! From this gross profit you must deduct the premium earlier paid to arrive at your net profit from the transaction. 

It is important for you to note that you can both buy or sell (i.e write) an option contract. Thus, if you have a bullish view on a particular security, you can always write a put option on the given security and pocket the premium.

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