The Basic Put
Option
A put option provides an investor with the
right, but not the obligation to sell a stock at a specific price.This price is
known as the strike, or exercise price.
If you believe a specific stock or market will
go downwards in near future you buy plain put option for that particular stock
or index.The price of this option moves opposite to underlying security price.
Writing Put Options for
Income
Buying a put option is similar to going short on
a stock, or profiting from a fall in the stock price. However, an
investor can also short, or write a put option. This lets him or her
receive income in the form of receiving the option price and the hope is the
stock remains above the strike price. If the stock falls below the strike
price, the put writer has the obligation to buy the stock (because it is
effectively “put” to him or her) from the put option holder. Again, this
occurs if the stock price falls below the exercise price.
When writing put options, the investor who is
short is betting that the stock price will remain above the exercise price
during the term of the option. When this happens, the investor is able to
keep the premium and earn income from the strategy.
Combining One Put with
Another Option
To create a more advanced strategy and
demonstrate the use of put options in practice, consider combining a put option
with a call option. This strategy is known as a straddle and consists of buying a put option as well as
going long a call option. In this case, the investor is speculating that
the stock is going to have a relatively significant move either up or
down.
For example, assume a stock trades at Rs 1000.
The straddle strategy can be relatively straightforward and consist of
purchasing both the put and call at a strike price of 1000. Two long options
are purchased with the same expiration date and a profit is reached if either
the stock moves up or down by more than the cost to purchase both
options.
Looking at an actual stock, shares of
Reliance recently traded around 1000 per share. A call option trades at
Rs 14 and a put option trades at Rs 15 for a total cost of Rs 28 for a single
contract. In this case, the stock would have to move up past Rs 1028 for
the call option to start to pay off and below Rs 972 for the put strategy to
start to pay off.
