Put Option Payoff Diagram Explained
- What does a put option payoff chart show?
- How does a put option writer earn (or lose)?
- Profit and loss outcomes for a put option buyer
- How to understand put option payoffs using diagrams
Why Traders Use Put Options in Falling Markets
In bearish or declining markets, traders commonly prefer buying put options over using Futures. Why? Because the risk in put options is predefined and limited to the premium paid. This makes it easier to manage your risk-reward balance, especially for directional trades.
Traders often use payoff diagrams to visualise their potential outcomes. These diagrams graphically represent profit/loss based on the movement of the underlying at expiry.
Interpreting the Put Payoff Diagram
Let’s break down the payoff for a trader who purchases a three-month Nifty Put option at a strike price of ₹17,000, paying a premium of ₹100.
- Lot size of Nifty = 50 units
- Premium outlay = ₹100 x 50 = ₹5,000
- Breakeven point = Strike price – Premium = ₹17,000 – ₹100 = ₹16,900
If Nifty’s spot price on expiry falls below ₹16,900, the trader makes a profit. The lower the spot price drops, the greater the profit potential.
However, if the price stays above ₹16,900, the trader either makes no profit or incurs a maximum loss of ₹5,000 (the premium paid). The profit potential is theoretically high, while the downside remains capped.
Sample P&L Table for Put Buyer
Nifty Closing Price | Payoff for Put Buyer (₹) |
|---|---|
16,700 | +200 |
16,800 | +100 |
16,900 | 0 |
17,000 | -100 |
17,100 | -100 |
17,200 | -100 |
17,300 | -100 |
This table reflects how profit rises as the market drops and how the maximum possible loss is capped at the premium paid, regardless of how high the index moves.
Role of the Put Option Writer
Every put contract has a counterparty called the Put Writer, who sells the option and receives the premium. The Put Writer initiates the trade, and their income is the premium collected.
- If the market stays above the strike price, the option expires worthless for the buyer, and the Put Writer keeps the entire premium as profit.
- If the market falls below the strike, the option is exercised, and the Put Writer begins incurring losses.
- The maximum loss a Put Writer may suffer is the entire strike price (since the lowest the underlying can fall is ₹0).
In contrast to a Call Option Writer—who faces unlimited risk if the market rises indefinitely, a put writer’s risk is technically capped at the strike price. That’s because a stock or index cannot go below zero.
Visualising Profit Zones for Writers and Buyers
The Put payoff diagram clearly distinguishes:
- Profit Zone for Buyer: Below breakeven (₹16,900 in the above example)
- Loss Zone for Buyer: Above strike price
- Profit Zone for Writer: Above strike price (entire premium earned)
- Loss Zone for Writer: Below strike price, with increasing loss as market falls
The writer’s loss equals the buyer’s gain, and vice versa. The deeper the fall below the strike, the more loss the writer absorbs.
Key Points to Remember
- Put options are widely used in falling markets because losses are limited to the premium paid.
- Payoff diagrams help traders understand the breakeven and visualise possible outcomes at expiry.
- Put Writers, often experienced traders with higher capital, initiate contracts to earn premiums.
- Buyer's profit = Writer's loss, and the reverse is true.
The writer’s profit is capped, but their loss, while technically limited to zero, is still considerable.