Options Explained: Put Options Part 2: Protective Puts

in #investing2 years ago

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One way to use options to protect you from losses is to buy puts. Put options give you the right to sell someone your stock at a previously agreed upon price. It is like insurance for your stock investment. In fact the money you pay to purchase the put option is called a premium, just like the payment you make for your car or homeowners insurance. The put option serves the same purpose, it protects you from a loss. And just like your insurance you have to pay for a put every month. I believe that put options were one of the first products sold on the options market.

Example:
Bob buys 1000 shares of Apple stock for 100$ per share. This costs him 100,000$.
His total investment is therefore $100,000.00 USD
His total investment at risk is also $100,000.00 USD.
If Apple has a bad earnings report the month Bob buys the shares, the price may drop.
If the price falls 25 dollars per share to 75$ Bob has lost 25$ times 1000 or 25,000$.
Many investors would sell the stock to limit their loss to 25,000$.
But Bob is different, Bob bought Put Options to protect his investment.
He paid 1$ per share or 1000$ for the right to sell his stock for 90$ per share.
When the stock price fell Bob “exercised his Option” to sell at 90$ and Bob git 90,000 of his investment back. Bob still lost 10,000$ plus the price of the Option 1000$, or a total of 11,000$. But Bob would have lost 25,000$ if he didn’t buy the Put option.
This Put protected him so his loss was only 11,000$. The 1000$ he paid for the Puts saved him 14,000$. This is called Buying a Protective Put.

Discussion:
This is a very common use of Options, as insurance. The small amount of premium is a worthwhile investment and in many cases is tax deductible. This requires a very limited understanding of options and that also makes it popular. Because Insurance is something everyone understands. I use this occasionally to protect large positions of frequently traded stocks, but I don’t need it for stocks I am Hodling for the longterm.

If you want to read more on using puts, read my other “Put Post “ 😂

I have listed the definitions for the common trading terms below.

✍🏼 By Shortsegments.

Bonus Material:

Option
An option is a contract between two parties in which the stock option buyer (holder) purchases the right (but not the obligation) to buy/sell 100 shares of an underlying stock at a predetermined price from/to the option seller (writer) within a fixed period of time.

Strike Price
The strike price is the price at which the underlying asset is to be bought or sold when the option is exercised. It's relation to the market value of the underlying asset affects the moneyness of the option and is a major determinant of the option's premium.

Premium
The amount of money per share you pay to purchase the option rights you seek, either to buy or sell stock share. The option premium depends on the strike price, volatility of the underlying, as well as the time remaining to expiration.

Expiration Date
The Calender date that you rights to buy or sell end. An option is a temporary agreement with an end date agreed upon at the time of purchase.

Put Option
A Put option is an option contract in which the buyer has the right (but not the obligation) to sell a specified quantity of a stock or some other security, at a pre-determined price (strike price) until a pre-determined date (expiration).
For the seller of the Put option it represents an obligation to buy the underlying security at the strike price, if the option is exercised. The put option seller is paid money (premium) for taking on the risk associated with the obligation.

Call Option
A call option is an option contract in which the buyer has the right (but not the obligation) to buy a specified quantity of a stock or some other security, at a pre-determined price (strike price) until a pre-determined date (expiration).
For the seller of the call option it represents an obligation to sell the underlying security at the strike price, if the option is exercised. The call option seller is paid money (premium) for taking on the risk associated with the obligation.

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