Table of Contents
What is Put Option?
Put Option is a contract between two parties under which option buyer gets the right to sell the underlying or original asset (Stock, bond, index, commodity) at pre-determined price (Strike Price) within a specified period.
But do remember, option buyer gets here right and not an obligation. That means its upon him whether he wants to use his right or not.
For buying the right put option buyer will pay an amount to put option seller that is called premium.
The put option buyer will make profit if the price of the underlying asset will decrease.
If the things not go well on or before the expiration date, that means price of the underlying asset move above the strike price, the maximum loss a put option buyer will bear would be the premium amount.
Payoff and Profit at The Expiry of PUT Option Contract
Buyer’s Perspective
The put option buyer will exercise his right only if he is in profit that means he will exercise his right only when market price is lower than strike price.
Put Option Buyer’s Payoff: – Strike Price – Market Price
Profit/Loss for Put Option Buyer: – Strike Price – Market Price – Premium
Seller’s Perspective
Put Option Seller’s Payoff: – – Strike Price – Market Price
Profit/Loss for Put Option Seller: – – Strike Price -Market Price – Premium
Example
Share Price of HDFC Bank (Here share of HDFC Bank is an underlying asset) is currently trading at Rs. 800 per share. Mr. Tony is an investor and after observing the current market situation he come to a conclusion that the market price of will fall within the period of one month. He entered into put option contract to sell share of HDFC Bank at strike price of Rs. 810 per share at the expiry of one month. Mr. Tony paid Rs. 15 per share premium for buying the put option.
Case-I: – Market Price of HDFC Bank at the expiry of contract- Rs. 770 per share
Mr. Tony has bought a put option, therefore he has right to sell share at Rs. 810. At the expiry of the contract market price of the share is Rs. 770 per share. As Mr. Tony can sell the share of HDFC Bank at a higher price as compare to market, he will exercise his right and, in this case, payoff would be Rs. 40 per share (810 – 770) and profit would be Rs. 25 per share ((Rs. 40 – Rs.15 (i.e. premium amount)).
| Why Mr. Tony exercised his right? Let’s understand this point with a normal life example. Suppose you are a seller and you have entered into a contract to sell any product after 1 month at a price of Rs. 1000. Suppose after 1 month market price of that product is Rs. 500. Then what you will do in this case? Yes, you will definitely sell that product for Rs. 1000 as per your contract and now as the market price of that product is Rs. 500 you can buy that product in the market and earn profit of Rs. 500. |
Case II: – Market Price of HDFC Bank at the expiry of contract- Rs. 800 per share
Mr. Tony has right to sell share at Rs. 810. At the expiry of the contract market price of the share is Rs. 800 per share. As Mr. Tony can sell the share of HDFC Bank at a higher price as compare to market, he will exercise his right and, in this case, payoff would be Rs. 10 per share (810 – 800) and loss would be Rs. 5 per share ((Rs. 10 – Rs.15 (i.e. premium amount)).
Case III: – Market Price of HDFC Bank at the expiry of contract- Rs. 810 per share or more than 810
As in this case payoff would either be Zero or in negative, Mr. Tony will not exercise his right. Therefore, loss would be Rs. 15 per share i.e. premium amount.
