I trust you're now familiar with both buyers and sellers perspectives on a call option. It is easy to learn about the call option if you are familiar with it. A put option's only difference (from the buyer’s perspective) is that the view on the markets should be bearish, as opposed to the bullish view held by a buyer of call options.
The buyer of a put option bets on the possibility that the stock price will fall (by expiry). To profit from this view, the buyer enters into a Put Option Agreement. A put option agreement allows the buyer to buy the right of selling a stock at a specified price (strike value), regardless of where the underlying/stock trades.
This is a general rule: whatever the buyer anticipates, the seller anticipates exactly the opposite. Therefore, a market exists. A market cannot exist if everyone expects the exact same thing. If the buyer of a put option expects that the market will fall by expiry, the seller of the put option would also expect the market (or stock) to rise or stay the same.
The right to sell the underpinning to the put writer at a set rate (Strike price) is purchased by a put option buyer. The put option seller will need to purchase the underlying to the writer at the strike price if the buyer is selling him. Attention: The put option seller sells a right at the time the agreement is made. At expiry, the buyer may'sell' his underlying rights to the seller.
Are you confused? You don't need to be confused.
Still, confusing? Don't worry, we will show you how to make this easier.
This is the Contract buyer vs Contract seller.
Let's build a case for the put option. First, we will discuss the Put Option from a buyer's point of view. Then, we will move on to the seller's side and explain the option.
Here's the Bank Nifty end-of-day chart (as of 8 thApril 2015).
Here are my thoughts on Bank Nifty.
This reasoning is why I prefer to purchase the 18400 Put Option at a premium Rs.315/. To purchase the 18400 option, I will need to pay Rs.315/- premium and this will be paid by the seller of the 18400 option.
The process of buying a put option is very simple. All you have to do is call your broker and ask him for the option to purchase a stock or strike. It will take only a few minutes. You can also buy the option yourself using a trading terminal like Stock market box Pi. We'll get into the details of selling and buying options via a terminal later.
Let's say I bought the 18400 Put Option from Bank Nifty. It would be fascinating to see the P&L behavior of the Put Option after it expires. We can also make some generalizations about the P&L behavior of a Put Option.
Before we can generalize the behavior of the Put Option P&L we must first understand how the intrinsic value is calculated. Intinctual value was discussed in the previous chapter. I assume that you are familiar with IV. The intrinsic value is the amount of money that the buyer would receive if he exercised the option after expiry.
The intrinsic value calculation for a Put option is slightly different to that for a Call option. I have attached the intrinsic value formula to a Call option in order to help you understand the difference.
spot price-strike price
The intrinsic value-
IV = Strike Price – Spot Price
Consider the following timeline to help you remember an important aspect of the intrinsic value and importance of an option:
We have only looked at the day that an option's intrinsic value is due. The series has a different method of computing the intrinsic value of an opportunity. We will learn how to calculate the intrinsic value of an option upon expiry. We only need to understand the calculation of the intrinsic price upon expiry.
Let's keep the idea of the intrinsic value of a put options in mind. Let us build a table to help us determine how much money I, the buyer of Bank Nifty 18400 put option, would make under various spot value changes by Bank Nifty (in spot market) upon expiry. Remember that the premium for this option is Rs. 315/- No matter how spot values change, the fact that Rs.315/= will not be changed. This is how much I paid to purchase the Bank Nifty 18400 put option. Let's keep this in mind and calculate the P&L table.
The negative sign preceding the premium paid is a cash flow from my trading accounts.
This is the general formula that you can use to calculate the P&L for a Put Option position. This formula can be used for positions that are not yet expired.
P&L = [Max (0, Strike Price - Spot Price)] - Premium Paid
Let's take 2 random numbers and see if this formula works.
@16510 Position must be profitable (spot below strike)
= Max (0.18400 -16510)]- 315
= 1890 - 315.
@19660 (spot over strike, position must be loss-making, premium only)
Max (0,18400 - 19660), - 315
Max (0, -1260), - 315
Both the expected and actual results are evident.
We also need to understand how a Put Option buyer calculates the breakeven point. As we have covered it in the previous chapter, I won't go into detail about the breakeven point. I will however give you the formula for calculating the same.
Breakeven point =
Strike price-premium price
The Bank Nifty breakeven point would then be
= 18400 - 315.
According to this definition, the breakeven point is 18085. The put option should not make or lose any money at 18085. Let's use the P&L formula to validate this.
Max (0,18400 - 180855) - 315
= Max (0, 315)- 315
= 315 - 315.
The results are clearly in line to the expectations of the breakeven point.
Important Note - All calculations of the intrinsic value and P&L are made with regard to the expiry.we wil assume that you as a n option buyer or seller has an intention to hold the option trade till expiry.
Soon you'll realize that you often initiate options trades only to close them before expiry. In such situations, while the calculation of breakeven point is not important, it does impact the calculation of P&L or intrinsic value. There is an alternative formula.
Let me illustrate this by assuming two scenarios for the Bank Nifty Trade. We know that the trade was initiated on 7 thApril 2015, and it expires on 30 thApril 2015.
The answer to the first question can be answered quite easily. We can apply the P&L formula straight away.
Max (0,18400 - 17000), - 315
Max (0, 1400)- 315
= 1400 - 315.
Let's move on to the 2nd and questions. If the spot was at 17000 on any other date than the expiry date then the P&L is not going to be 1085. It will be higher. This will be discussed later. This is what you need to remember for now.
We can see the generalizations that we made about the Put Option buyers P&L points if we connect them and create a line chart.
These are some things you should take into consideration from the chart. Remember that 18400 is the strike rate.