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This article is written by Pallavi Chandrasekhar who is pursuing a Diploma in Advanced Contract Drafting, Negotiation and Dispute Resolution from LawSikho.

Introduction

A put option clause gives the owner of that option a right to sell a certain amount of assets or shares at a fixed price within a fixed time.  It does not give the owner an obligation to sell.  The put option buyer usually thinks that the underlying share would sell below this fixed price (the price this asset must reach for the put option to be valuable to both the buyer and the seller) before that fixed time or date.  A call option, on the other hand, gives the owner of the call option a right to buy the underlying share at a fixed price on or before a fixed expiration date.

A put option’s value increases when the cost of the underlying price reduces because she has a fixed price on the share to sell.  She would be selling it at a higher price than its market value and thereby making a profit.  Thus, when an investor buys a put option, she wants the underlying price of the share to depreciate.  Similarly, the put option’s value reduces if the underlying share’s value increases.

It also must be stated that a put option contract is merely an agreement dealing with an asset.  Hence, it is called a derivative as its value is derived from the fluctuating price of the actual asset.  

Put Option Basics

Put option or “put” or “puts” can be traded on various options such stocks, currencies, commodities, bonds, futures, and indexes.  The purchaser of a put may sell or use the underlying asset at specified fixed price called the “strike price” (price at which the underlying asset can be purchased or sold).  A put option’s value also declines when the expiration date gets closer.  

Benefits for a domestic investor

  • Since put options when used are given a short position in the underlying stock, it is often used for hedging or to speculate the downside of prices.  Investors use this option clause as a risk-management method called ‘protective put’.  This method is like an insurance on investment to make sure that the loss on the underlying stock does exceed the strike price.  In case the domestic investor chooses not to exercise her put option, she only loses the initial contract price, or the premium paid for the put option and not the actual price of the underlying asset.
  • In case of hedging, put options can help investors utilize leverage because the amount of investment is very low (only put option contract price has to be paid).  This enables the domestic investor to pay a small amount and take a high exposure.
  • It gives the investor an opportunity for high payoffs with low risks.
  • The investment made by the investor is very less and it allows her to a large position by making a small investment.
  • It allows the investor the flexibility to use the market’s volatility and profit from it.

Types of Put Options: The value of the put declines as its expiration date comes near because the chances of the price of the stock falling below the strike price are reduced

  • In the money or ITM”:  When the put option exceeds its expiration date, the intrinsic or actual value of the asset remains.  This is equal to the difference between the strike price and the actual underlying stock price.  If an option has an intrinsic value, it is termed as ITM.  
  • Out of the money or OTM”: where the strike price is lower than the underlying stock’s market value.
  • At the money ATM”: where the strike price and market value of the underlying asset are the same, the put options have no inherent value as there would be no gains in using the option.  
  • American put option: It allows the use of the put option any time before its expiration.
  • European put option: It allows the owner to use the put option for a short period of time before its expiration.

Example of put option at work

An investor purchases a put option contract with Gucci for Rs. 100.  Each of her option contracts has 100 shares.  The exercise price of the share is Rs. 10, and the current price of each Gucci share is Rs. 12.  The put option clause in her contract has given her the right, but not an obligation, to sell 100 Gucci shares at Rs. 10/- each.  If Gucci’s shares drop to Rs. 7 per share, the investor has an ITM put (which means the strike price is below the market price) and she can close her option by selling the shares or the contract in the market.

The investor also has an option of purchasing more Gucci shares at Rs. 7 per share.  Let us say she purchases 100 more Gucci shares for Rs. 700 to use her put option at Rs. 10 per share.  If we ignore commissions, the profit for using her put option is Rs. 300 (1,000-700).  She had also paid Rs. 100 for the put option contract.  Including that, her total profit would be Rs. 200 (300-100).

Similarly, if the investor previously owned 100 Gucci shares and also purchased another !00 shares for Rs. 7 each, her position is called a ‘married put’ option.  In a married put, the investor can use her position to hedge against any decrease in the price of the shares.

Elements while drafting a put option contract

  1. It must include a “grant of put option” clause that details the right to sell, the procedure, the completion of sale, cooperation, and closing of the sale.  For example: 

Grant of put option

  1. Right to sell: Subject to the other terms and conditions of this contract, starting from January 1st, 2021 till January 1st, 2022 (“Put Exercise Period”); the shareholder shall have the right (“Put Right”), but no obligation to cause the company to buy a part or all parts of the shares at the Put Purchase Price.
  2. Procedure: 
        • If the shareholder wishes to sell any of the shares in accordance with part (a) of this clause, the shareholder shall give to the company a written, unconditional, and irrevocable notice (“Put Exercise Notice”) exercising her Put Right and specifying the number of shares to be sold (“Put Shares”).
        • By giving the Put Exercise Notice, the shareholder represents and warrants to the company that: 
            • She has the full right, title, and interest in and to the shares, 
            • She has all the required power and authority, and has taken all the necessary steps to sell the shares as needed under clause (c) of this part, and
            • The shares are free and clear of all mortgages, pledges, security interests, options, rights of first offer, encumbrances or other restrictions or limitations of any nature other than those arising from this contract.
        • Subject to the Completion of Sale clause herein below, the closing of any sale of shares under this section shall take place within 90 days of receipt of the Put Exercise Notice by the company.  The company shall give the shareholder atleast 10 days written notice of the closing date (“Put Right Closing Date”)
        • If the shareholder does not give the company a Put Exercise Notice during the Put Exercise Period, any rights of the shareholder that requires the company to buy the shares according to this contract shall be terminated and shall not be in force or effect.
          • Completion of Sale: The company shall pay the shareholder the Put Purchase Price by a certified check or wire transfer on the Put Right Closing Date.
          • Cooperation: The shareholder and company shall take all reasonable actions and steps to complete the sale according to this section of the contract, including without limitation entering into new agreements, giving certificates, instruments, consents as maybe needed.
          • Closing: At the time of closing of sale made under this section of this contract, the shareholder shall give the company certificate(s) of shares to be sold, along with the share powers, and all required tax paid, stamps fixed, if needed, with the receipt of the Put Purchase Price.

2. Define the put purchase price.  For example: 

Put Purchase Price: If the shareholder uses her Put Right under this contract, the purchase price per share at which the company will have to buy the put shares (“Put Purchase Price”) shall be equal to the Original Purchase Price of the put shares , with any unpaid profits on the put shares through the Put Right Closing Date.  “Original Purchase Price” shall mean the price actually paid by the shareholder for the put shares.

3. Boilerplate clauses such as notices, dispute resolution mechanism, jurisdiction, severability, governing law, jurisdiction clauses, waiver clauses, force majeure, etc. 

Conclusion

Trade experts state that most investors are scared of using option contracts (whether call or put option) as they lack awareness about the various derivative instruments available to them in the market.  But once investors understand how put option clauses can help hedge their investments and make money, it would be more frequently used.

During the COVID-19 pandemic that started at the beginning of the year 2020, several companies have seen the value of their stocks and shares drop.  This means that holders of put options would benefit from the decreasing value of the share price.  However, it remains to be seen if buyers of such put options have used the pandemic to refuse to buy the put shares citing force majeure and the general plummet of stock prices all over the world.

References

  1. https://www.investopedia.com/terms/p/put.asp
  2. https://en.wikipedia.org/wiki/Put_option
  3. https://www.sec.gov/Archives/edgar/data/1715495/000119312517376767/d492339dex1a6matctrct7.htm
  4. https://www.businesstoday.in/moneytoday/investment/all-about-options-how-investors-can-use-them/story/202674.html

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