If you are about to open a trading account and are thinking of trading in derivatives, you should know what put options are. Along with call options, put options are one of the most popular types of options in the market.
A put option gives its buyer a right (not an obligation) to sell an underlying asset to a counterparty at a predetermined price on or before a specific date. Remember a put option’s buyer has a right not an obligation. Hence, he can choose not to exercise the put option.
However, the seller of a put option has the obligation to buy an underlying asset from the buyer of the option. The seller has the obligation, not the right. But, why would a seller do so?.
When a seller sells a put option, the buyer pays him an option premium. Now, let us understand the pros and cons of trading put options.
Pros of Trading Put Options
1. Can Help You Capitalise The Bearish Market
When the market turns bearish and stock prices fall, you can buy put options because they provide you with a right to sell an asset at a predetermined price. Suppose you buy a put option and the price of the underlying stock falls below the exercise price of the option, you stand to gain.
2. Limited Potential Of A Loss
The maximum loss a put option’s buyer can incur is the amount of premium he has paid to the option’s seller. Let us say that you have a put option that allows you to sell a stock at ₹100 on or before December 31 and you have paid ₹5 premium to buy it.
Suppose the price of the stock remains more than ₹100 till December 31. Hence, you will not exercise the option. Your losses are limited to ₹5 (option premium). Besides, you know how much you will lose if you do not exercise the option. Hence, there is no uncertainty about it.
3. Can Generate Significant Profits
Suppose you buy a put option to sell a stock at ₹100 on or before December 31 by paying a premium of ₹5. If the stock’s price falls to ₹80, you will generate a profit of ₹15 (₹100 – ₹80 – ₹5). If the stock’s price falls even more by December 31, your profits will increase as well.
Cons Of Trading Put Options:
1. Limited Potential To Earn A Profit For A Seller
If you are selling a put option, the maximum profit you can earn is the option premium. Besides, for you to earn the option premium as a profit, it is necessary that the buyer does not exercise the option. When will he not exercise the option? Only when he can sell the underlying stock at a higher price than the put option allows him to.
2. A Seller Can Incur Significant Losses
If the price of an underlying asset keeps falling, a put option’s seller can incur huge losses. Hence, you should sell a put option only if you are very sure that a price of an asset is unlikely to fall beyond a point. Otherwise, the asset’s market price will fall like anything and you will be forced to buy it at a much higher price from the person to whom you had sold the option.
3. Option Premium Can Be Very High For A Buyer
When the price of an underlying asset is highly volatile due to extreme uncertainty, you may have to pay a very high premium to buy a put option on it. This is because a put option will give you a right to sell it at a predetermined price. If the price keeps on falling, the option’s seller can incur considerable losses. Hence, he will charge a high premium to sell you the option.
Conclusion
New traders who are about to open a trading account should not rush to trade in put options. Such options can be extremely risky. Hence, they should first understand how put options work and develop a feel for the market. Once they have sufficient knowledge, they should start trading in put options.
