Buying Wheat Put Options to Profit from a Fall in Wheat Prices

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Short selling versus put options: a guide for investors

Short selling and buying put options can be used to profit from falling share prices. But what differentiates the two approaches and how do they stack up against each other?

Put options

With options, we pay a non-refundable sum of money, known as a contract premium, to gain the chance to profit from a move in an underlying security price.

Buying a call option allows us to profit from upward moves in shares, whereas buying a put option enables us to profit from down moves.

Buying a put option, otherwise known as taking a ‘long-put’ position, provides us with the opportunity to theoretically sell an underlying share at a predetermined price and by a certain date.

In practice, when an option contract position has gone our way, we should be able to simply close the position with one click on our laptop to realise profits.

When we purchase a put option, our maximum loss is always limited to the contract premium.

Profiting from puts

For example, suppose the shares of DriverlessCar Company are trading at $160, as at 1 May. A put option contract with a strike price of $150 expiring in a month from now is priced at $3.

We expect the stock price to fall over the coming weeks; we pay $3,000 to acquire put options covering 1000 shares.

Fortunately for us, at option expiry the share price has fallen to $140. Our put options are now ‘in the money’ with a total intrinsic value of $10,000 and we can now sell them for that amount.

In this simplistic example, the intrinsic value of our put options is equal to the difference between the strike price and the option price at expiry multiplied by the number of shares being covered by the contracts.

As we paid $3,000 to buy the put options, our profit from the position is $7,000:

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Profit= $10,000 intrinsic value – $3,000 contract premium = $7,000

Limited risk

While put options can offer attractive returns, the downside is limited. Suppose the share price of DriverlessCar remains in a fairly narrow range before rising sharply at contract expiry to $185 after the company reports strong results from new product launches.

In this case, the put option was unprofitable, or in other words remaining ‘out of the money’.

On the bright side, even though the shares rose sharply before our option contracts expired, our loss is still limited to the $3,000 in premiums we paid at initiation on 1 May. The profit potential on a long put is also limited as a share cannot fall below zero.

While long puts can be used for speculative reasons, they are well suited for hedging the risk of a decline in the conventional portfolios and shares that we hold.

Consider the situation of a fund manager who is compelled by their mandate to always hold a certain percentage of a portfolio in equites during all market conditions, including bear markets.

Gains from long-put positions can be a welcome relief, offsetting at least some of the losses from conventional shareholdings.

At other times, rises in the value of our traditional holdings can easily counterbalance the contract premiums paid for our put options.

Low probability

It may all sound too good to be true, but the probability of an option contract being ‘in the money’ and providing us with a profit in its own right is typically only 25%.

The probability is a function of the volatility of the option and the length of the contract; the higher both these factors are, the more likely it is that the strike price on the long-put contract will be reached.

When it comes to options, volatility could be thought of as our friend – higher share price volatility increases our chances of making a profit. In a low volatility situation, when an underlying share price remains virtually unchanged, we´ve still lost the option premium that we paid at the initiation of the contract.

However, the cost of contracts on stocks with higher volatility will also be greater, reducing our potential for profit.

Buying contracts on stocks with lower volatility, but which we believe hold strong potential for share price movement due to events, can prove to be better value.

Some stocks are a lot more volatile than others, with ‘beta’ commonly used as a measure of share price volatility.

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For instance, a share with a beta of 0.9 could be thought of as being 10% less volatile than the market average. A share with a beta of 1.2 is theoretically 20% more volatile than the market.

Short selling

Like long puts, short selling enables us to profit from downward movements in share prices. As with puts, the potential gains are limited because a share price cannot fall below zero.

However, unlike using puts, the potential losses from short selling are theoretically unlimited.

To initiate a short-selling trade, we must borrow shares and then sell them in the market. If the share price drops as we hope, we can then buy them back at a lower price.

This price difference forms the basis of our profit from the trade. However, if the share price rises sharply, we are fully exposed to the resulting losses.

If the price does rise significantly, we could be compelled to provide additional margin (the money a broker requires as security for a trade) in addition to the initial margin we would have had to post at the outset of the trade.

Margin of error

One advantage of put options is that there is no such margin (borrowing) requirement involved. Typically, 50% of the total sale amount must be posted as margin at initiation of a short-selling trade.

This equates to $80,000 if we had sold short 1,000 shares in DriverlessCar Company when the share price was at $160 on 1 May.

If the share price had fallen to $140 as in the earlier example, our potential profit from short selling would have been:

($160 – $140) x 1,000 = $20,000

If the shares had subsequently risen to $185, our paper loss from short selling would have been:

($185 – $160) x 1,000 = $25,000

In this scenario, the put option contracts appear much more favourable as our losses were limited to $3,000.

Short selling entails less risk when the security being shorted is a market index or an exchange-traded fund (ETF). This is because individual shares carry much more potential for sharper movements.

Regulations have been imposed in recent years to make short selling more transparent. Some of the larger short-sale positions of financial institutions can be viewed on regulators´ websites.

*excludes cost of borrowing stock short or any interest payable on margin account.

Time advantage

On the flip side, short selling offers the advantage of time. Unlike with a put, there is no time limit on the trade, provided of course that we can keep funding any additional margin requirements that may be due to the broker.

While the holder of a put option´s losses are strictly limited to the contract premiums they pay at initiation, an option is highly likely to expire out of the money.

In contrast, the short seller could choose to wait it out if they believe the share price will fall in the long term. While being significantly more expensive than long puts, and with much higher potential losses, the short seller gets the advantage of time.

Short selling or long puts?

Both short selling or long puts can be used either to speculate or as a means to hedge risk.

Due to the risks involved, short selling should only be contemplated by sophisticated investors with deep pockets.

As the risk of loss from a long-put contract is limited to just the premiums paid at initiation, put options are likely to be much more suitable for the average investor.

To learn how short selling can work for your trading strategy watch our video:

The Put Option Buying

5.1 – Getting the orientation right

I hope by now you are through with the practicalities of a Call option from both the buyers and sellers perspective. If you are indeed familiar with the call option then orienting yourself to understand ‘Put Options’ is fairly easy. The only change in a put option (from the buyer’s perspective) is the view on markets should be bearish as opposed to the bullish view of a call option buyer.

The put option buyer is betting on the fact that the stock price will go down (by the time expiry approaches). Hence in order to profit from this view he enters into a Put Option agreement. In a put option agreement, the buyer of the put option can buy the right to sell a stock at a price (strike price) irrespective of where the underlying/stock is trading at.

Remember this generality – whatever the buyer of the option anticipates, the seller anticipates the exact opposite, therefore a market exists. After all, if everyone expects the same a market can never exist. So if the Put option buyer expects the market to go down by expiry, then the put option seller would expect the market (or the stock) to go up or stay flat.

A put option buyer buys the right to sell the underlying to the put option writer at a predetermined rate (Strike price. This means the put option seller, upon expiry will have to buy if the ‘put option buyer’ is selling him. Pay attention here – at the time of the agreement the put option seller is selling a right to the put option buyer where in the buyer can ‘sell’ the underlying to the ‘put option seller’ at the time of expiry.

Confusing? well, just think of the ‘Put Option’ as a simple contract where two parties meet today and agree to enter into a transaction based on the price of an underlying –

  • The party agreeing to pay a premium is called the ‘contract buyer’ and the party receiving the premium is called the ‘contract seller’
  • The contract buyer pays a premium and buys himself a right
  • The contract seller receives the premium and obligates himself
  • The contract buyer will decide whether or not to exercise his right on the expiry day
  • If the contract buyer decides to exercise his right then he gets to sell the underlying (maybe a stock) at the agreed price (strike price) and the contract seller will be obligated to buy this underlying from the contract buyer
  • Obviously the contract buyer will exercise his right only if the underlying price is trading below the strike price – this means by virtue of the contract the buyer holds, he can sell the underlying at a much higher price to the contract seller when the same underlying is trading at a lower price in the open market.

Still confusing? Fear not, we will deal with an example to understand this more clearly.

Consider this situation, between the Contract buyer and the Contract seller

  • Assume Reliance Industries is trading at Rs.850/-
  • Contract buyer buys the right to sell Reliance to contract seller at Rs.850/- upon expiry
  • To obtain this right, contract buyer has to pay a premium to the contract seller
  • Against the receipt of the premium contract seller will agree to buy Reliance Industries shares at Rs.850/- upon expiry but only if contract buyer wants him to buy it from him
  • For example if upon expiry Reliance is at Rs.820/- then contract buyer can demand contract seller to buy Reliance at Rs.850/- from him
  • This means contract buyer can enjoy the benefit of selling Reliance at Rs.850/- when it is trading at a lower price in the open market (Rs.820/-)
  • If Reliance is trading at Rs.850/- or higher upon expiry (say Rs.870/-) it does not make sense for contract buyer to exercise his right and ask contract seller to buy the shares from him at Rs.850/-. This is quite obvious since he can sell it at a higher rate in the open market
  • A agreement of this sort where one obtains the right to sell the underlying asset upon expiry is called a ‘Put option’
  • Contract seller will be obligated to buy Reliance at Rs.850/- from contract buyer because he has sold Reliance 850 Put Option to contract buyer

I hope the above discussion has given you the required orientation to the Put Options. If you are still confused, it is alright as I’m certain you will develop more clarity as we proceed further. However there are 3 key points you need to be aware of at this stage –

  • The buyer of the put option is bearish about the underlying asset, while the seller of the put option is neutral or bullish on the same underlying
  • The buyer of the put option has the right to sell the underlying asset upon expiry at the strike price
  • The seller of the put option is obligated (since he receives an upfront premium) to buy the underlying asset at the strike price from the put option buyer if the buyer wishes to exercise his right.

5.2 – Building a case for a Put Option buyer

Like we did with the call option, let us build a practical case to understand the put option better. We will first deal with the Put Option from the buyer’s perspective and then proceed to understand the put option from the seller’s perspective.

Here is the end of day chart of Bank Nifty (as on 8 th April 2020) –

Here are some of my thoughts with respect to Bank Nifty –

  1. Bank Nifty is trading at 18417
  2. 2 days ago Bank Nifty tested its resistance level of 18550 (resistance level highlighted by a green horizontal line)
  3. I consider 18550 as resistance since there is a price action zone at this level which is well spaced in time (for people who are not familiar with the concept of resistance I would suggest you read about it here
  4. I have highlighted the price action zone in a blue rectangular boxes
  5. On 7 th of April (yesterday) RBI maintained a status quo on the monetary rates – they kept the key central bank rates unchanged (as you may know RBI monetary policy is the most important event for Bank Nifty)
  6. Hence in the backdrop of a technical resistance and lack of any key fundamental trigger, banks may not be the flavor of the season in the markets
  7. As result of which traders may want to sell banks and buy something else which is the flavor of the season
  8. For these reasons I have a bearish bias towards Bank Nifty
  9. However shorting futures maybe a bit risky as the overall market is bullish, it is only the banking sector which is lacking luster
  10. Under circumstances such as these employing an option is best, hence buying a Put Option on the bank Nifty may make sense
  11. Remember when you buy a put option you benefit when the underlying goes down

Backed by this reasoning, I would prefer to buy the 18400 Put Option which is trading at a premium of Rs.315/-. Remember to buy this 18400 Put option, I will have to pay the required premium (Rs.315/- in this case) and the same will be received by the 18400 Put option seller.

Of course buying the Put option is quite simple – the easiest way is to call your broker and ask him to buy the Put option of a specific stock and strike and it will be done for you in matter of a few seconds. Alternatively you can buy it yourself through a trading terminal such as Zerodha Pi We will get into the technicalities of buying and selling options via a trading terminal at a later stage.

Now assuming I have bought Bank Nifty’s 18400 Put Option, it would be interesting to observe the P&L behavior of the Put Option upon its expiry. In the process we can even make a few generalizations about the behavior of a Put option’s P&L.

5.3 – Intrinsic Value (IV) of a Put Option

Before we proceed to generalize the behavior of the Put Option P&L, we need to understand the calculation of the intrinsic value of a Put option. We discussed the concept of intrinsic value in the previous chapter; hence I will assume you know the concept behind IV. Intrinsic Value represents the value of money the buyer will receive if he were to exercise the option upon expiry.

The calculation for the intrinsic value of a Put option is slightly different from that of a call option. To help you appreciate the difference let me post here the intrinsic value formula for a Call option –

IV (Call option) = Spot Price – Strike Price

The intrinsic value of a Put option is –

IV (Put Option) = Strike Price – Spot Price

I want you to remember an important aspect here with respect to the intrinsic value of an option – consider the following timeline –

The formula to calculate the intrinsic value of an option that we have just looked at, is applicable only on the day of the expiry. However the calculation of intrinsic value of an option is different during the series. Of course we will understand how to calculate (and the need to calculate) the intrinsic value of an option during the expiry. But for now, we only need to know the calculation of the intrinsic value upon expiry.

5.4 – P&L behavior of the Put Option buyer

Keeping the concept of intrinsic value of a put option at the back of our mind, let us work towards building a table which would help us identify how much money, I as the buyer of Bank Nifty’s 18400 put option would make under the various possible spot value changes of Bank Nifty (in spot market) on expiry. Do remember the premium paid for this option is Rs 315/–. Irrespective of how the spot value changes, the fact that I have paid Rs.315/- will remain unchanged. This is the cost that I have incurred in order to buy the Bank Nifty 18400 Put Option. Let us keep this in perspective and work out the P&L table –

Please note – the negative sign before the premium paid represents a cash outflow from my trading account.

Serial No. Possible values of spot Premium Paid Intrinsic Value (IV) P&L (IV + Premium)
01 16195 -315 18400 – 16195 = 2205 2205 + (-315) = + 1890
02 16510 -315 18400 – 16510 = 1890 1890 + (-315)= + 1575
03 16825 -315 18400 – 16825 = 1575 1575 + (-315) = + 1260
04 17140 -315 18400 – 17140 = 1260 1260 + (-315) = + 945
05 17455 -315 18400 – 17455 = 945 945 + (-315) = + 630
06 17770 -315 18400 – 17770 = 630 630 + (-315) = + 315
07 18085 -315 18400 – 18085 = 315 315 + (-315) = 0
08 18400 -315 18400 – 18400 = 0 0 + (-315)= – 315
09 18715 -315 18400 – 18715 = 0 0 + (-315) = -315
10 19030 -315 18400 – 19030 = 0 0 + (-315) = -315
11 19345 -315 18400 – 19345 = 0 0 + (-315) = -315
12 19660 -315 18400 – 19660 = 0 0 + (-315) = -315

Let us make some observations on the behavior of the P&L (and also make a few P&L generalizations). For the above discussion, set your eyes at row number 8 as your reference point –

  1. The objective behind buying a put option is to benefit from a falling price. As we can see, the profit increases as and when the price decreases in the spot market (with reference to the strike price of 18400).
    1. Generalization 1 – Buyers of Put Options are profitable as and when the spot price goes below the strike price. In other words buy a put option only when you are bearish about the underlying
  2. As the spot price goes above the strike price (18400) the position starts to make a loss. However the loss is restricted to the extent of the premium paid, which in this case is Rs.315/-
    1. Generalization 2 – A put option buyer experiences a loss when the spot price goes higher than the strike price. However the maximum loss is restricted to the extent of the premium the put option buyer has paid.

Here is a general formula using which you can calculate the P&L from a Put Option position. Do bear in mind this formula is applicable on positions held till expiry.

P&L = [Max (0, Strike Price – Spot Price)] – Premium Paid

Let us pick 2 random values and evaluate if the formula works –

@16510 (spot below strike, position has to be profitable)

= Max (0, 18400 -16510)] – 315

= + 1575

@19660 (spot above strike, position has to be loss making, restricted to premium paid)

= Max (0, 18400 – 19660) – 315

= Max (0, -1260) – 315

= – 315

Clearly both the results match the expected outcome.

Further, we need to understand the breakeven point calculation for a Put Option buyer. Note, I will take the liberty of skipping the explanation of a breakeven point as we have already dealt with it in the previous chapter; hence I will give you the formula to calculate the same –

Breakeven point = Strike Price – Premium Paid

For the Bank Nifty breakeven point would be

So as per this definition of the breakeven point, at 18085 the put option should neither make any money nor lose any money. To validate this let us apply the P&L formula –

= Max (0, 18400 – 18085) – 315

=0

The result obtained in clearly in line with the expectation of the breakeven point.

Important note – The calculation of the intrinsic value, P&L, and Breakeven point are all with respect to the expiry. So far in this module, we have assumed that you as an option buyer or seller would set up the option trade with an intention to hold the same till expiry.

But soon you will realize that that more often than not, you will initiate an options trade only to close it much earlier than expiry. Under such a situation the calculations of breakeven point may not matter much, however the calculation of the P&L and intrinsic value does matter and there is a different formula to do the same.

To put this more clearly let me assume two situations on the Bank Nifty Trade, we know the trade has been initiated on 7 th April 2020 and the expiry is on 30 th April 2020–

  1. What would be the P&L assuming spot is at 17000 on 30 th April 2020?
  2. What would be the P&L assuming spot is at 17000 on 15 th April 2020 (or for that matter any other date apart from the expiry date)

Answer to the first question is fairly simple, we can straight way apply the P&L formula –

= Max (0, 18400 – 17000) – 315

= Max (0, 1400) – 315

= 1085

Going on to the 2 nd question, if the spot is at 17000 on any other date apart from the expiry date, the P&L is not going to be 1085, it will be higher. We will discuss why this will be higher at an appropriate stage, but for now just keep this point in the back of your mind.

5.5 – Put option buyer’s P&L payoff

If we connect the P&L points of the Put Option and develop a line chart, we should be able to observe the generalizations we have made on the Put option buyers P&L. Please find below the same –

Here are a few things that you should appreciate from the chart above, remember 18400 is the strike price –

  1. The Put option buyer experienced a loss only when the spot price goes above the strike price (18400 and above)
  2. However this loss is limited to the extent of the premium paid
  3. The Put Option buyer will experience an exponential gain as and when the spot price trades below the strike price
  4. The gains can be potentially unlimited
  5. At the breakeven point (18085) the put option buyer neither makes money nor losses money. You can observe that at the breakeven point, the P&L graph just recovers from a loss making situation to a neutral situation. It is only above this point the put option buyer would start to make money.

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