Put Options: How to Profit from Falling Markets

Understanding Put Options: Sell Without Owning

When you expect weakness in the broader market or a specific stock, the instinctive strategy is to sell high and buy low. For example, if you believe the price of A Ltd will drop from ₹100 to ₹80, you might consider selling it now and repurchasing it later. This helps reduce your holding cost and allows you to stay invested in the long run. But there's a catch—you can only use this strategy if you already own the stock.

That’s where put options on m.Stock come into play. They allow you to take advantage of a falling market without actually holding the stock. A put option gives you the right (not the obligation) to sell a stock or index at a predetermined price on or before a future date. It’s the inverse of a call option, which gives the right to buy.

How a Put Option Works in Practice

Let’s say your technical view suggests that Infosys stock is likely to decline. On August 10, 2022, you don’t hold Infosys shares, but you're confident the price will fall. So instead of short-selling or entering into a future contract, you buy a put option.

For instance:

• You purchase Infy September 2022 PE 1,500 OTM at ₹20 (lot size: 600).
• Total cost: ₹12,000.
• By August 29, Infosys drops below ₹1,500 and the premium rises to ₹65.
• Net profit: ₹45 per share × 600 = ₹27,000 on a ₹12,000 investment.

If you had opted for a futures position instead, margin requirements would have been significantly higher, reducing your ROI. Moreover, your downside risk in futures would be much higher than the limited risk (premium paid) in put options.

Call vs. Put Options: A Side-by-Side Snapshot

Hedging with Put Options

Put options aren't just for speculators. Long-term investors can also use them as a protective strategy. Let’s revisit the Infosys example:

If you already hold 100 Infosys shares and expect a short-term dip, one approach is to sell and repurchase at lower levels. But frequent buying and selling can trigger tax liabilities and affect long-term capital gains benefits.

Instead, you could buy a put option to hedge. If the stock drops from ₹1,600 to ₹1,500:

• Selling and buying back earns you ₹10,000.
• A put option bought at ₹20 and sold at ₹65 earns you ₹27,000, without selling the shares.

Thus, put options let you protect downside risk while continuing to hold your long-term investments.

Who Are Put Option Writers?

For every buyer, there’s a seller. Put option writers (the sellers) earn the premium when they sell the option, expecting that the stock price will stay above the strike price.

In the Infosys scenario:

• If the stock stays above ₹1,500, the put expires worthless.
• The writer keeps the ₹20 premium as profit.
• If it falls below ₹1,500, the writer faces losses, though limited, as the stock can’t drop below zero.

Compared to call writers who face unlimited loss potential, put writers deal with limited downside. Additionally, selling puts can be a strategy to own stocks below market price if the option is exercised.

Naked Put Options: High-Risk, High-Reward

A naked put (or uncovered put) is when a trader sells a put option without having a short position in the underlying stock.

This is a bullish stance:

• The writer believes the price will stay above the strike.
• If correct, they keep the premium as maximum profit.
• If wrong, and the stock falls, they must buy it at the strike price, potentially incurring losses.

This strategy suits experienced traders who understand risk management and have the capital to cover positions if exercised.

Things to Remember

• Put options can be used for speculation or protection by long-term investors.
• A put option buyer profits when the underlying price falls.
• Compared to call writers, put writers face limited but uncertain risk.

Naked puts are advanced strategies and involve writing puts without a hedge or short position.