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, youll 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 lets say the option expires after 5 days

Now lets 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. Lets 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, lets 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 buyers (Ram) account while the sellers (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 Rams and Shyams account respectively.

Ram Buyer

Debit Credit Premium Rs 2

Shyam Seller

Debit

Credit Premium Rs. 2

Day 1
Rams 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, Rams account will not be credited by this profit till he settles or squares off his contract. However, Shyams account would be debited by Rs 2 since he is obliged to honor the contract.

Ram Buyer

Debit Credit Premium Rs 2 Rs 2

Shyam Seller

Debit

Credit Premium Rs. 2

Day 1 (notional profit Rs. 2)

Day 1

Rs 2

Day 2
Closing Price on day two 95

Rams gross notional profit now is Rs. 5 and Shyams loss

compared to the previous closing price is Rs. 3. So, in the end, Rams account gets credited notionally by Rs 3 as shown in the tables below.

Ram Buyer

Debit Credit Premium Rs 2 Rs 2 Rs 3

Shyam Seller

Debit

Credit Premium Rs. 2

Day 1 Day 2 (notional profit Rs. 5)

Day 1 Day 2

Rs 2 Rs 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 3

Closing Price on day Three 96 Rams notional profit comes down to Rs. 4 and Shyams account would get credited by Rs 1.

Ram Buyer

Debit Credit Premium Rs 2 Rs 2 Rs. 3 Rs 1

Shyam Seller

Debit

Credit Premium Rs. 1

Day 1 Day 2 Day 3 (notional profit Rs. 4)

Day 1 Day 2 Day 3

Rs 2 Rs. 3 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 4
Closing Price on day Four 97 Rams notional profit will come down to Rs. 3 and

Shyams account would get credited by Rs 1.

Ram Buyer Day 1

Debit Premium Rs 2

Credit

Shyam Seller Day 1

Debit

Credit Premium Rs 2

Rs 2

Rs 2

Day 2
Day 3 Day 4 (notional profit Rs. 3) Rs 1 Rs 1

Rs. 3

Day 2
Day 3 Day 4

Rs. 3
Rs 1 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 Rams notional profit would increase to Rs.7. So at

the end of day 5 (settlement day), Rams account

with his broker would get credited by Rs 7 while Shyams account would get debited by Rs. 7.

Ram Buyer Day 1 Day 2 Day 3 Day 4 Day 5

Debit Credit Premium Rs 2 Rs 2 Rs. 3 Rs 1 Rs 1 Rs 4

Shyam Seller Day 1 Day 2 Day 3 Day 4 Day 5

Debit

Credit Premium Rs 2

Rs 2 Rs. 3 Rs 1 Rs 1 Rs 4

Day 5 Settlement Date

Thus the effect of the 5 days leading to the settlement would look like this

Ram Buyer
Day 1 Day 2 Day 3 Day 4 Day 5

Debit Premium Rs 2

Credit

Shyam Seller
Day 1 Day 2 Day 3 Day 4

Debit

Credit Premium Rs 2

Rs 2 Rs. 3 Rs 1 Rs 1 Rs 4

Rs 2 Rs. 3 Rs 1 Rs 1 Rs 4 Rs 9 Rs 7 Rs 2

Day 5 Total Net Loss

Total

Rs 2

Rs 9

Net gain Rs. 7

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.

Ram Buyer
Day 1 Day 2 Day 3 Day 4 Day 5 Total Net gain

Debit Credit Premium Rs 2

Rs 2 Rs. 3 Rs 1 Rs 1 Rs 4 Rs 2 Rs 9

Shyam Seller
Day 1 Day 2 Day 3 Day 4 Day 5 Total Net Loss

Debit

Credit Premium Rs 2

Rs 2 Rs. 3 Rs 1 Rs 1 Rs 4 Rs 9 Rs 2

Rs. 7 Rs. 2 = Rs. 5

Rs 7 Rs. 2 = 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.