Put option
Also written Put option (on a bond) · Put · Long put · Put contract · Right to sell
A contract giving its buyer the right, but never the obligation, to sell the underlying at a fixed strike price — insurance against a fall, bought for a premium.
In plain language
A put option is an insurance policy on a price.
The NISM workbook makes the comparison directly: when you insure your car you pay a premium, and the insurer promises to make good the damage. If nothing happens, the insurer keeps the premium. You have bought a put option on your car.
A put on a government security works the same way. You pay a premium today for the right to sell the bond at a fixed strike price on the expiry day. If the bond falls below that strike — which is what happens when yields rise — you exercise and are made whole. If it does not, you let the option lapse and your loss is the premium and nothing else.
The person on the other side, the writer, has sold that promise. He keeps the premium if nothing happens, and has no choice but to perform if it does.
How it works
The put buyer on a bond is taking a view that prices will fall — that is, that yields will rise. A bond portfolio that has to survive a monetary policy review is the standard case: the holder is already long the bond, and a put converts an open-ended loss into a known premium.
At expiry the buyer compares spot with strike. Spot below strike: exercise, and collect the difference. Spot at or above strike: let it lapse, because the bond can be sold higher in the market than the strike offers.
The arithmetic has one boundary the call does not. A bond price cannot fall below zero, so the put buyer's gain is capped at the strike less the premium, and the writer's loss is capped at the same figure. The workbook still describes the option seller's risk as theoretically unlimited, which is the answer to give in the paper; the bound is worth knowing so the pay-off table reads correctly.
As with calls, the premium is intrinsic value plus time value, and time value decays to zero by expiry. Indian exchange-traded interest rate options are European, premium-style and cash settled, so a buyer who changes his mind squares off rather than exercising early.
The formula
Intrinsic value of a put = max(Strike − Spot, 0)
Time value = Premium − Intrinsic value
Buyer pay-off at expiry = max(X − S, 0) − P
Writer pay-off at expiry = P − max(X − S, 0)
Break-even at expiry = X − P (same for buyer and writer)
One lot is notional bonds of face value Rs 2,00,000 — 2,000 units — so a premium quoted in rupees per 100 of face value becomes money when multiplied by 2,000.
A worked example
The workbook's own trade. On 1 October 2021, 6.10% GOI 2031 is trading at Rs 98.40. You buy the 98.50 put at a premium of Rs 0.30, expiring 28 October 2021. One lot = 2,000 units.
Cash out on day one: 0.30 × 2,000 = Rs 600.
Break-even = 98.50 − 0.30 = Rs 98.20.
| Bond price at expiry | Intrinsic (B) | Buyer pay-off per 100 | Buyer per lot | Writer per lot |
|---|---|---|---|---|
| 97.00 | 1.50 | +1.20 | +Rs 2,400 | −Rs 2,400 |
| 97.50 | 1.00 | +0.70 | +Rs 1,400 | −Rs 1,400 |
| 98.00 | 0.50 | +0.20 | +Rs 400 | −Rs 400 |
| 98.20 | 0.30 | 0.00 | Rs 0 | Rs 0 |
| 98.50 | 0.00 | −0.30 | −Rs 600 | +Rs 600 |
| 98.75 | 0.00 | −0.30 | −Rs 600 | +Rs 600 |
At Rs 98.00 the buyer exercises, selling at 98.50 what the market values at 98.00: a gross gain of Rs 0.50, or Rs 1,000 a lot. Against the Rs 600 already paid, the net is Rs 400. On cash settlement he simply receives the Rs 1,000 of intrinsic value. The writer, mirror image, keeps Rs 600 and pays out Rs 1,000, for a net loss of Rs 400.
Squaring off instead of exercising. The workbook's 4.8.5 illustration. A dealer hedging Rs 100 crore of G-secs buys 5,000 lots of the October 6.10% GOI 2031 put at a strike of Rs 101.00 when the quote is Rs 0.20 / 0.21. He pays the offer: 5,000 × 0.21 = Rs 1,050. He sells the underlying bonds on 15 October and cancels the hedge the same day, when the contract is quoted Rs 0.10 / 0.11. He hits the bid: 5,000 × 0.10 = Rs 500. Net loss of Rs 550 — the cost of carrying the insurance for a fortnight, plus the bid-offer spread paid twice.
Why NISM asks about it
Chapter 4 (Exchange Traded Interest Rate Options) is the home chapter: 4.1 for terminology, 4.4 for the moneyness table, 4.8.3 and 4.8.4 for the long and short put pay-off tables reproduced above, 4.8.5 for the square-off arithmetic. The put reappears in Chapter 5 as the protective put, the standard way a bond holder insures a portfolio ahead of a policy review.
Expect to compute a break-even, to state the maximum loss per lot, to place a given strike and spot in the moneyness table, and to answer the recurring "option buyer faces ______ risk and option seller faces ______ risk" — limited and unlimited, in that order.
Common exam traps
- A put is in the money when the strike is above the spot — the exact reverse of a call. Most marks lost on this chapter are lost here.
- Break-even is strike minus premium for a put, and strike plus premium for a call. Both sides of the contract share the same break-even.
- The buyer's loss is the premium in rupees per lot. Rs 0.30 is Rs 600, not Rs 0.30.
- Buying a put on a G-sec is a view that yields will rise. Rising rates push bond prices down, which is what the put is insuring against.
- Higher interest rates reduce a put's value; higher volatility and longer time to expiry raise it, exactly as they raise a call's. Only the spot, strike and interest-rate rows of the workbook's table point in opposite directions for calls and puts.
- Long a put is a short position on the underlying, even though you are "long" the option. The workbook flags this separation of long-on-option from long-position explicitly.
- The seller of a put is not exposed to a literally infinite loss — price stops at zero, so the bound is strike less premium — but the workbook's answer to the risk question is still "unlimited".
Where this is taught
- Series XII · Chapter 6: Derivative Marketsintroduced here
- Series IV · Chapter 1: Introduction to Interest Rate, Interest Rate Instruments and Fixed Income Marketsintroduced here
- Series XVI · Chapter 4: Commodity Optionsintroduced here
- Series XXI-B · Chapter 5: Derivativesintroduced here
- Series VIII · Chapter 4: Introduction to Optionsintroduced here
- Series XIX-A · Chapter 10: Fund Monitoring, Reporting and Exitintroduced here
- Series VI · Chapter 11: Special Services - Debt Instruments & Government Securitiesintroduced here
- Series V-D · Chapter 21: Exchange Traded Interest Rate Optionsintroduced here
- Series XIX-C · Chapter 15: Fund Monitoring, Reporting and Exitintroduced here
- Series XXI-A · Chapter 5: Derivativesintroduced here
- Series XIX-D · Chapter 12: Fund Monitoring, Reporting and Exitintroduced here
- Series IV · Chapter 4: Exchange Traded Interest Rate Options
Related terms
- Intrinsic valueWhat an asset is actually worth — the present value of the cash it will generate over its remaining life, as against whatever price the market is quoting today.
- Break-even pointThe level of the underlying at which a position makes neither profit nor loss — for a bought call, strike plus premium; for a bought put, strike minus premium.
- Call optionA contract giving its buyer the right, but never the obligation, to buy the underlying at a fixed strike price — so the loss is capped at the premium and the gain is not.
- MoneynessWhether exercising an option right now would give the buyer a positive, zero or negative cash flow — classifying it as in the money, at the money or out of the money.
- OptionA contract giving the buyer the right, but not the obligation, to buy or sell the underlying at a stated price on or before a stated date, in exchange for a premium paid to the writer.
- Protective putBuying a put option to protect a foreign currency receivable: it sets a floor rate (strike minus premium) while keeping the benefit if the currency rises. Suited to contingent cash flows.
- Strike priceThe price fixed in an option contract at which the buyer may buy (call) or sell (put) the underlying if he chooses to exercise — fixed for the life of the contract, unlike the premium.
- Time valueThe part of an option premium that is not intrinsic value — what the buyer pays for the possibility that the underlying moves further in his favour before expiry. It falls to zero on expiry day.
- HedgerA participant who already carries interest rate risk from a real business exposure and uses derivatives to remove it, rather than to take a view on the market.
- Option premiumThe price an option buyer pays the seller for the right the contract carries — non-refundable, and made up of intrinsic value plus time value.
- Wasting assetAn option, whose time value shrinks towards zero every day it is held and is worth nothing at expiry — so an option buyer loses money simply from the passage of time.
- Long-only Equity StrategyA Category III AIF strategy that takes only buy positions in selected stocks when investing, aiming at absolute returns over the medium to long term with a strong emphasis on capital preservation.
- SwaptionAn option on a swap — the right, not the obligation, to enter an interest rate swap at a predetermined strike rate on a future date, bought for a premium.
- Interest Rate FloorA series of interest rate put options that pays the buyer at the end of each period in which the underlying interest rate is below the strike rate — protection against falling rates.
- Bermudan optionAn option that can be exercised only on specific dates named in the contract, usually near expiry — more flexible than a European option, less flexible than an American one.
- Perfect Negative CorrelationA correlation coefficient of −1: two assets' returns move in opposite directions, delivering the complete benefit of diversification and making a zero-risk combination possible.
- Naked putIn this workbook, a put option taken for trading or speculation with no portfolio behind it — the counterpart of a protective put, which insures holdings the investor already owns.
- Asymmetric risk exposureThe defining pay-off feature of options: gains when the underlying moves one way differ sharply from losses when it moves the other way. Futures, by contrast, have symmetric exposure.
- ExercisePutting an option's right into effect: a call holder buys the underlying at the strike, a put holder sells at the strike. In cash settled IRD options the holder simply receives the difference.
- Intrinsic and time valueThe two components of an option's premium — intrinsic value, the amount the option is currently in the money by, and time value, the extra a buyer pays for the chance the option becomes more valuable before expiry.
- Right of First OfferA shareholders' agreement right requiring a selling shareholder to obtain the holder's best offer first, and to sell to the holder at that price if the market cannot beat it.
- Secondaries marketThe sale of an existing investor's fund units or partnership interest to co-investors or outside buyers, usually at a negotiated discount to net asset value.
- Residual put optionA put option that promoters agree to only as a fallback: the AIF cannot exercise it unless the company fails to list within an agreed time or the AIF cannot use the other exit routes.
- Vertical spreadTwo options of the same type and the same expiry but different strikes, one bought and one sold — a limited-profit, limited-loss position that trades away part of the upside to cut the cost or cap the risk.
- Covered callHolding the underlying in the cash market and writing a call against it — a way of earning premium income from a holding, at the cost of capping the gain above the strike.
- Put-call parityThe arbitrage-free relationship binding a European call and put of the same strike and expiry to the spot and the discounted strike: c + X·e^(−rt) = p + S. Deviations create risk-free profit.
- Put-Call RatioPut open interest (or volume) divided by call open interest on the same underlying, read as a contrarian sentiment gauge: below 1 is taken as bearish, above 1 as bullish.
- Definitive AgreementsThe binding agreements signed between an investee company and the investment manager representing the AIF to complete an investment — chiefly the share subscription agreement and the shareholders' agreement.
- Secondary SaleAn AIF exit in which it sells its stake in a portfolio company to a third party — often another AIF, such as a later-stage PE fund taking over from a VC fund — rather than exiting through an IPO.
- Currency optionAn option giving the buyer the right, but not the obligation, to buy or sell an agreed amount of one currency against another at a specified exchange rate, on or before a specified future date.
- Contingent cash flowA foreign currency receipt or payment that may not happen at all — an unconfirmed order or an unsuccessful bid — for which the workbook prefers bought options to futures, because the loss is capped at the premium.
- CollarAn options strategy extending a covered call: hold the stock, sell a call above the price and buy a put below it, putting a floor under losses in exchange for a lower cap on profits.
- Asymmetric payoffA payoff where gains when the underlying moves one way differ sharply from losses when it moves the other — the defining feature of options, as against the symmetric, linear payoff of futures.
- European optionAn option that can be exercised only on its expiry date. Indian equity options are European — coded CE for calls and PE for puts — unlike American options, exercisable any time up to expiry.