Understanding how a typical Option Deal is done in the market – Put Option

Understanding how a typical Option Deal is done in the market – Put Option – By Prof. Simply Simple TM I hope the last lesson on ‘Options’ helped you in getting to understand the concept. In continuation of that, we also discussed the ‘Call’ option for your clarity on the subject.

Having explained the ‘Call’ option, quite naturally, you’ll want to know about the ‘Put’ option. Let me try & explain to you how this kind of an Option Deal is practically done in the market place.

In the stock market there are several participants who are both buyers and sellers…

A stock market is a platform where this is free flow of information…

This is so that the current stock price is known to every participant (buyers and sellers) Any participant trying to extract a higher price will not be able to do so because of the free flow of information which prevents any sort of price arbitrage. This is what we call ‘Price Discovery’.

Now lets say there is a stock option on stock A, which is currently quoting at Rs.100. And let’s say the option expires after 5 days…

Now let’s say there are two participants “Ram” & “Shyam” in this market. Ram is of the view that the stock prices would fall to Rs. 80 in the near future. But Ram does not want to take a risk (i.e. in case the price rises to Rs 120).

Hence he chooses to ‘buy’ a put option which protects him against any rise in price. For getting this service, he would have to pay a premium to the seller of the option. The seller of the option, Shyam, on the other hand has a view that the price of the stock will rise.

But what if the contract gives Ram the “option” of (either) • Selling the stock to Shyam at the pre-agreed price of Rs 100 (or) • Choosing to exit the contract In other words, Ram is given the option of not honoring the contract made with Shyam on the date of settlement.

However, it is not that bad a situation for Shyam as it appears as he gets compensated by Ram for having been a party to the ‘Options’ contract. • This compensation * in the form of price is called the “Option Premium” that Ram has to pay for the Options contract and is usually a small amount. • Let’s assume in our case the amount is Rs 2. • So Ram is obliged to pay Shyam Rs 2 towards the cost of compensation for having such an option. * Please note that the Ram will have to pay an option premium regardless of whether or not the option is actually exercised.

To understand this better, let’s assume that Ram has bought a put option at the strike price of Rs. 100 (i.e. the price at which he gets a right to sell the stock ‘A’ in the future to the seller of the put option i.e. Shyam). Now, look at how the prices move in these 5 days and what implications it has for Ram & Shyam…

Day 1 It is important to understand that this trade starts with a debit balance of Rs 2 ( the premium) in the buyer’s (Ram) account while the seller’s (Shyam) account would show a credit balance of the Shyame amount ( Rs 2 – Premium amount). Further, it is imperative to know that Rs. 2 is the maximum debit and credit which can occur in Ram’s and Shyam’s account respectively.

Day 1 Ram’s buying price of the Option on day “One” – 100 Closing Price on day “One” – 98 His notional profit at the end of day “One” – Rs. 2 But, unlike futures, Ram’s account will not be credited by this profit till he settles or squares off his contract. However, Shyam’s account would be debited by Rs 2 since he is obliged to honor the contract.

Day 2 Closing Price on day “two” – 95 Ram’s gross notional profit now is Rs. 5 and Shyam’s loss compared to the previous closing price is Rs. 3. So, in the end, Ram’s account gets credited notionally by Rs 3 as shown in the tables below. Ram can cash out his notional profit today by assigning his put option to Shyam. Shyam cannot exit the contract; however; he can pass on his probable future obligation to some other participants by honoring the losses till date.

Closing Price on day “Three” – 96 Ram’s notional profit comes down to Rs. 4 and Shyam’s account would get credited by Rs 1. Day 3 Ram can cash out his notional profit today by assigning his put option to Shyam. Shyam cannot exit the contract; however; he can pass on his probable future obligation to some other participants by honoring the losses till date.

Day 4 Closing Price on day “Four” – 97 Ram’s notional profit will come down to Rs. 3 and Shyam’s account would get credited by Rs 1. Ram can cash out his notional profit today by assigning his put option to Shyam. Shyam cannot exit the contract; however; he can pass on his probable future obligation to some other participants by honoring the losses till date.

Day 5 – Settlement Date Closing Price on day “Five” – 93 Ram’s notional profit would increase to Rs.7. So at the end of day 5 (settlement day), Ram’s account with his broker would get credited by Rs 7 while Shyam’s account would get debited by Rs. 7.

Day 5 – Settlement Date Thus the effect of the 5 days leading to the settlement would look like this…

Day 5 – Settlement Date Taking the ‘Option Premium’ into account, the Put Option buyer has a net gain of Rs 5 while the Put Option seller has a net loss of Rs 5.

Thus the ‘Put Option” seller has unlimited risk while the “Put Option” buyer takes a much lesser risk!

Phew! That was quite a tough one. I hope you have got some understanding of this esoteric concept which dodges the brightest brains many a times.

Please do let me know if I have managed to clear this concept for you. Your feedback is very important to me as it helps me plan my future lessons. Please give your feedback at professor@tataamc.com

Disclaimer The views expressed in these lessons are for information purposes only and do not construe to be of any investment, legal or taxation advice. They are not indicative of future market trends, nor is Tata Asset Management Ltd. attempting to predict the same. Reprinting any part of this presentation will be at your own risk and Tata Asset Management Ltd. will not be liable for the consequences of any such action.

Understanding how a typical Option Deal is done in the market – Put Option