Chapter 4

What is a Put Option?

Do you have health insurance? If you don’t, here’s why you should get one. Say Person A is 20 years old and has bought a health insurance cover for ₹1 lakh. She is paying an annual premium of ₹5,000. 

Now, two months later, say, Person A was hospitalised to have her appendix removed. The procedure cost her ₹50,000. But what did she pay? Nothing. Instead the insurance company paid for the hospitalisation and surgery cost. So Person A ended up with net savings or gains of ₹45,000 (₹50,000 minus ₹5,000 premium).

Here, Person A assumed she would fall ill at some point and prepared for it. A put option works in a similar fashion. You believe the value of the underlying will fall and prepare to profit from it.  

Which brings us back to trading options and put options in particular. A Put Option is similar to the health insurance in this example. Read on to know all about Put options. 

What is a Put Option?

A Put Option is a contract that gives the holder the right, but not the obligation, to sell the underlying security at a predefined price at a certain date.

Know Your Put Options

As discussed in the last chapter on call options, there are a few key components associated with Put Options: the underlying, the option premium or cost, the expiration date, and the strike price. We will get into more detail on each of these individual concepts but here is a quick overview and how they relate to the car insurance example above.

• Underlying and underlying price: The underlying is the security that the option is based on.
  • Relationship to the example: The underlying is comparable to your new car. So, the put option is based on the underlying stock or index while the insurance policy is based on the car. The underlying price is comparable to the price you paid, or the value of your new car.
• Expiration date: Just like with Call Options, Put Options also have limited lifespans. When traders are interested in purchasing a put option, they can use the Option Chain to select from a range of expiration dates.
  • Relationship to the example: The term that the ‘car insurance policy is in-force’ is comparable to a put option expiration date.
• Strike Price: Just like with call options, the strike price is the set price at which the option can be exercised.
  • Relationship to the example: The deductible is similar to the strike price. If you set your deductible high, you will pay a low premium. With strike prices, if you choose a strike price that is far away from being ‘valuable’, then the premium you pay to buy the option will be lower. (We will cover what determines the ‘value’ of the option shortly in this chapter).  However, the important concept to understand at this time is that there is a trade-off between strike price and option premium (or cost).
• Options premium or cost: To purchase a Put Option, you will pay a premium, or cost, upfront.
  • Relationship to the example: This is directly comparable to the premium you would pay in our car insurance example. As with the car insurance example, your premium will vary based on the strike price (or deductible). In addition, you will pay more for the call option premium for expiration dates that are further in the future. This is similar to car insurance; if you want to have your policy in-force for longer, you will pay a higher premium.
• Strike Price: In some health insurance policies, you are required to pay a ‘deductible’. This has to be paid by you if you raise a claim. The balance is paid by the insurance company.This deductible is similar to the strike price. If you set your deductible high, you will pay a low premium.

Just like with call options, the strike price is the set price at which the put option can be exercised. If you choose a strike price that is far away from being ‘valuable’, then the premium you pay to buy the option will be lower. (We will cover what determines the ‘value’ of the option shortly in this chapter).  However, the important concept to understand at this time is that there is a trade-off between strike price and option premium (or cost).

To Conclude:

That’s all about Put Options. However, before we move ahead, we have a little bonus for you - a ‘cheat sheet’ that will summarise Call and Put options for you. Apologies if the following reminds you of your school book, but we promise, it will be helpful. 

Now that you know the difference between Call and Put options, let’s understand what it means to go long or go short. We will cover that in the next chapter.