5.1 - Ways for the Right Orientation

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.

• The contract buyer is the party that agrees to pay a premium, while the seller is the one who receives the premium.
• Contract buyers pay a premium to buy a right.
• The premium is paid to the contract seller, and obligates.
• Contract buyers will decide whether to exercise their right at the expiry date
• If the contract buyer exercises his right, he can sell the underlying (or stock) at the agreed prices (strike price), and the contract seller will be bound to purchase this underlying from him.
• The contract buyer can only exercise his right if the price of the underlying falls below the strike price. This means that if the same underlying is traded at a lower price on the open market, the buyer can sell it at a higher price to the seller.

Still, confusing? Don't worry, we will show you how to make this easier.

This is the Contract buyer vs Contract seller.

• Assume Reliance Industries trades at Rs.850/.
• Contract buyer purchases the right to buy Reliance from contract seller at Rs.850/e upon expiry
• This right is only available to contract buyers who pay a premium to contract sellers to obtain it
• Contract seller will buy Reliance Industries shares for Rs.850/- on expiry, but only if the contract buyer asks him to do so.
•    For example-The contract eller can demand contract buyer to buy Reliance at Rs.850/- if Reliance expiry is at Rs. 820/-  
• Contract buyers can now sell Reliance at Rs.850/– when it is trading at an open market price of Rs.820/–
•  Reliance trading at Rs.850/or more after expiry (say Rs.870/o), is it not logical that contract buyer exercise his rights and request contract seller to buy the shares at Rs.850/o The shares can be sold on the open market at a higher price. This is evident.  
• This agreement gives one the right to dispose of the asset at expiry. It is also known as a "Put option".
• Because he sold Reliance 850 Put Option, the contract seller will have to purchase Reliance at Rs.850/– from the contract buyer.
• I trust that you have gained the necessary knowledge about the Put Options from the discussion. It's okay to be confused. I am sure you will get more clarity as we go on. There are three key points that you should be aware of at this point.
  • The buyer of the option is bearish on the underlying asset while the seller is neutral or bullish.
  • The buyer of the option can sell the underlying asset at strike price upon expiry
  • If the buyer exercises his right to exercise the option, the seller of the put options is obliged to purchase the underlying asset from the buyer at strike price.

  5.2 - Case to sell the put option buyer

  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).
  (IMAGE 1)
   

  Here are my thoughts on Bank Nifty.

  1. Bank Nifty trades at 18417
  2. Bank Nifty's resistance level of 18550 was tested 2 days ago (resistance level highlighted with a green horizontalline)
  3.   18550 is what I consider resistance, because this price action area is well-paced in time. (I recommend that you read about resistance if you are not familiar with it).  
  4. I highlighted the price action area in the blue rectangular boxes.
  5. The RBI maintained a status-quo on the monetary rate, keeping the key central bank rates the same (as Bank Nifty may have known, RBI's monetary policy is the most important event).
  6. Banks may not be the season's most popular in the market due to technical resistance and the absence of any fundamental trigger.
  7. This may lead traders to want to sell their banks and purchase something that is more seasonally appropriate.
  8. These are the reasons why I am a bearish bank Nifty fan
  9. Although shorting futures may seem risky, the overall market is bullish. It is only the bank sector that is lacking in lustre.
  10. In such circumstances, an option can be the best. Therefore, buying a put option on Nifty bank may be a good idea.
  11. When the underlying falls, you get a benefit from a put option.

  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.
  (IMAGe 2
   

  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.

  5.3 - Put option Intrinsic value (IV) 

  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.

      IV(put) =
  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:
  (IMAGE3)
   

  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.

  5.4 - P&L behaviour (Put option buyer)

  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.
  (CHART
   

  1. A put option is bought to profit from a falling market price. when the price decrease in spot market ,the profit increases as we can see(strike price= 18400)  
     1. Generalization 1 Put Options buyers are financially profitable when the spot price falls below the strike price. Put options should only be purchased if you are negative about the underlying.
  2. The position begins to lose value as the spot price rises above the strike price (18400). The loss is limited to the amount of the premium paid in this instance, which is Rs.315/.
     1. Generalization 2: A buyer of a put option suffers a loss if the spot price is higher than the strike. The maximum loss is limited to how much the put option buyer paid.

  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.

  1. 16510
  2. 19660

  @16510 Position must be profitable (spot below strike)

  = Max (0.18400 -16510)]- 315

  = 1890 - 315.

  = +1575

  @19660 (spot over strike, position must be loss-making, premium only)

  Max (0,18400 - 19660), - 315

  Max (0, -1260), - 315

  = 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.

  = 18085

  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.

  = 0

  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.

  1. What would the P&L be if the spot was at 17000 on the April 2015?
  2.     Assuming the spot on 30th April 2015 at 17000 ,what would be the P&L?  

  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.

  = 1085

   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.  

  5.5 - Put option Buyer -payoff

  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.

  
  (IMAGE4)
   

  These are some things you should take into consideration from the chart. Remember that 18400 is the strike rate.

  1. Only when the spot price rises above the strike price (18400 or higher) did the Put option buyer experience a loss.
  2. This loss is however limited by the amount of premium paid
  3. When the spot price trades lower than the strike price, the Put Option buyer will see an exponential increase in his profits
  4. Potentially unlimited gains are possible
  5. The breakeven point (18085) is the point at which the buyer of put options neither loses money nor makes money. As you can see, at the breakeven point the P&L graph only recovers from a loss-making position to a neutral one. Only above this point, the put option buyer will start to make money.

  Key points

  1. If you are worried about the prospects for the underlying, it is a good idea to buy a put option. A Put option buyer can only be profitable if the underlying falls in value.
  2. A Put option's intrinsic value calculation is slightly different from a call option's.
  3. IV = Strike Price – Spot Price
  4. The P&L for a Put Option buyer is calculated as P&L = [Max (0. Strike Price – Spot Price)] – Premium Paid
  5. The Strike – Premium Paid is the breakeven point for the buyer of put options.