InvestorQ : What are the justifications for buying put options?

# What are the justifications for buying put options?

2 years ago

When you buy a put option, you are basically purchasing a right to sell an asset at a future date at a fixed price. What are the circumstances under which a put option is purchased? Here are a few classic cases under which the put option can be bought.

· When you are bearish on a stock. This is the most common reason for buying a put option. When the stock price goes down, the intrinsic value of the put option also goes up and this results in the value of the put option also going up. Put option is a good way of playing a bearish market or bearish action in a stock with limited contrary risk.

· Put option can also be bought when you expect the volatility of the stock to go up. This has nothing to do with the price. Even if the price of the stock moves little and the put volatility goes up sharply, then the Put option can benefit substantially. Check out the table below.

 Inputs Inputs Stock Price Now (Ps) ? 1,110 Stock Price Now (Ps) ? 1,115 Standard Dev - Annual (s) 20.00% Standard Dev - Annual (s) 40.00% Risk free Rate - Annual (R) 6.00% Risk free Rate - Annual (R) 6.00% Exercise Price (E) ? 1,100 Exercise Price (E) ? 1,100 Time To Maturity - Years (T) 0.0833 Time To Maturity - Years (T) 0.0833 Dividend yield (d) 1.00% Dividend yield (d) 1.00% Outputs Outputs d1 0.258 d1 0.211 d2 0.200 d2 0.096 N(d1) 0.602 N(d1) 0.584 N(d2) 0.579 N(d2) 0.538 Call Price (Vc) ? 33.31 Call Price (Vc) ? 61.21 -d1 -0.258 -d1 -0.211 -d2 -0.200 -d2 -0.096 N(-d1) 0.398 N(-d1) 0.416 N(-d2) 0.421 N(-d2) 0.462 Put Price (Pp) ? 18.75 Put Price (Pp) ? 41.65

The put side of the option valuation is really interesting. As you can see the stock price has actually gone up and that is negative for put option. In fact, on a standalone basis, the increase in price would have resulting in the put option value falling by Rs.2. However, what we have done here is to increase the volatility from 20% to 40%. As a result, despite the rise in stock price (which is negative for put options), we have the put value going up from Rs.18.75 to Rs.41.65, largely driven by the sharply higher volatility. Thus you can use put options to play volatility even if the price movement is unlikely to be favourable.

· Put options can also be very useful as a hedge. If you are long on a stock or on the Futures of a stock or an index and if the price of the futures goes down then you are exposed. To protect yourself, you can buy a lower strike put option and that will protect your downside risk.

Put options can also be used to create a spread in the market by buying a higher strike put and by selling a lower strike put. This will ensure that the spread is captured and your cost of put options is reduced.

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