Hopefully you are now aware of the practical aspects of a Call option from the point of view of both buyers and sellers. Learning about Put Options is quite simple since there is only one key difference for buyers; when buying a put option, their outlook on the markets should be bearish, unlike that of individuals purchasing Calls which is bullish.
The put option buyer is betting that the stock will decrease in price by expiry, so they enter into a Put Option contract. This gives them the right to sell a stock at a previously set rate (strike price), regardless of where it might be trading at that point in time.
Remember this general rule – whatever the option buyer is expecting, the seller will be anticipating the opposite. This is essential in order to create a market; if everyone was expecting the same result, then there wouldn’t be one. So if the Put option buyer believes that the stock will go down before expiry, then the Put option seller would anticipate that it will consistently remain at its current level or go up.
A put option buyer obtains the right to sell the underlying asset to the put option writer at an agreed-upon rate (the Strike price). This gives the put option seller an obligation to purchase, if desired by the put option buyer, when it expires. When they enter into this agreement, the put option seller is selling a privilege to the put option buyer which allows them to “sell” the underlying asset to them at expiry.
We can simplify the ‘Put Option’ as an agreement between two parties to execute a transaction depending on the price of something that is underlying.
o The individual that will be paying the premium is known as the ‘contract buyer’, and who will receive it is referred to as the ‘contract seller’.
o The buyer of the contract pays a premium in exchange for acquiring a right.
o The contract seller receives the premium and obligates himself
o On the day of expiration, it is up to the contract buyer to determine whether or not to exercise their right.
o The contract buyer has the right to exercise and sell the underlying, such as a stock, to the contract seller at the strike price. The contract seller will then be held responsible for purchasing this underlying from the buyer.
o The contract buyer will certainly seize the opportunity if the underlying asset is trading below the strike price. This enables them to sell the asset at a price significantly higher than its current market value.
Do not worry if it is still not making sense – let us illustrate this concept with an example to make things more straightforward.
Let’s assume the following situation for the Contract buyer and the Contract seller –
o Let’s say that Reliance Industries is trading at Rs.850/-
o A contract buyer has the right to sell Reliance to a contract seller at Rs.850 upon expiration.
o To secure this right, the contract buyer must pay a premium to the contract seller.
o In return for the premium, the contract seller agrees to buy Reliance Industries shares at a price of Rs. 850/- upon expiration, but only if the contract buyer chooses to exercise their right to sell.
o For instance, once Reliance reaches Rs.820/- when the contract expires, the buyer is able to require the seller to purchase it from them at Rs.850/-.
o This provides contract buyers with the opportunity to reap the advantages of selling Reliance at a rate of Rs.850/-, which is higher than the present market rate (Rs.820/-).
o If Reliance is trading at Rs.870/- or more at expiry, it would be foolish for the contract buyer to exercise their right and ask the contract seller to buy the shares at Rs.850/- as they can be sold in the open market for a higher rate.
o A ‘Put option’ is a type of agreement in which one is given the ability to sell the underlying asset upon expiration.
o Due to selling the Reliance 850 Put Option to the contract buyer, the contract seller will be obligated to buy Reliance Industries shares at a price of Rs. 850/-.
This discussion should have provided the necessary insight into Put Options. Even if you are still confused, it is alright, since you will likely gain more understanding as we continue. However, there are some key points that should be noted at this point –
o The buyer of the put option has a pessimistic outlook on the underlying asset, whereas the seller is either neutral or optimistic.
o Once the expiration date is reached, the owner of a put option has the privilege to offer the underlying asset at the predetermined price.
o The seller of the put option is obliged to purchase the underlying asset from the put option buyer at the strike price, in exchange for the upfront premium they receive. Unless instructed otherwise, this obligation stands.