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You hear us talking about buying and selling options, both calls and puts, but maybe you have no idea what any of these things mean. In this Article, we explain the basics of put options. Here, we analogize purchasing a put option to the well-known example of car insurance:
If you missed our post explaining the basics of call options, be sure to check it out here!
You can either buy or sell options contracts. When you buy an option, there is someone selling that option contract to you. You, as a consumer, buy car insurance to protect against any damage that might occur to your car. For that protection, you pay a premium to the insurance company. The insurer, on the other hand, sells you the duly tailored insurance policy. Usually, the more expensive the car the higher insurance premium because the insurance company will have to cover more complex and costlier losses or repairs. Similarly, higher risk drivers pay higher premiums since their risk of accident predicts higher outlays for the insurers, who have the statistics down to a science. If they don’t, they will not be in business for long. The obvious goal of the insurance company is to sell you premiums and never have to pay out any claims so they can pocket the cash.
Your unexpired insurance contract enables you to file a claim to collect money for duly covered/assessed vehicle damages. And so it is with buying a put options— like buying the car-insurance contracts in many ways. You can buy a put contract to protect you from losses in value of any stock you have pre-designated (but don’t actually have to own). For such protection, you pay an option “premium” to the option seller to protect you from losses for a specified period of time, anywhere between a week and over a year. The higher the stock price, the higher the cost for that option contract. Likewise, the more likely the loss (as in the case of a volatile stock), the higher the option price.
When buying an option contract, the purchaser has the right, but not the obligation to sell the underlying asset at a set price on or before said option’s expiration date. For this right, the buyer pays a “premium” to the option’s seller. So let’s say you own shares of XYZ stock, but you think it might go down in the next month. You could buy a put contract to insure any losses that might occur within the next month by giving you the right to sell off your shares at the agreed-upon price to the put-option seller. The options seller is obligated to take the shares from you at that agreed upon price, if you, the put buyer, choose to exercise the contract.
The goal of the option seller is to just collect the premium that the option buyer pays (and for that buyer to never exercise the put contract) so that the seller can pocket the cash.
You own 100 shares of ABC stock at $15.00/share = $1,500.00.
1. You buy a put option that expires in 1 month for $0.16. The price at which any losses are protected is $15.00 (also called the strike price).
2. The price of stock goes up to $20.00 at the end of the one month. Your option becomes worthless and you lost $0.16 because you never needed to use the insurance. The option seller keeps the $0.16. But if the stock price goes down to $7.00. You can still sell the stock to the option seller at $15.00 because you have a put contract. With the put contract you only lose the “premium” you paid to the option seller, i.e., 16¢. You avoided losing $8.00/share, or $800 total.
Another type of option is the call option— the exact opposite of a put option. A call option gives the call buyer the right to buy shares at a specified price during a specified period preceding expiration. The value in a call option is that it allows the call option buyer to buy shares at a cheaper price, if the call buyer thinks the shares might go up in the future.
Other examples include the selling of puts and calls. Come back to this Blog to learn more about these and additional strategies.
If you found this article helpful on the basic concept of a put option or you have any questions, leave a comment below!
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