What Are Options | Put Options Explained
When investing in the stock market most investors employ a unidirectional approach. They purchase stock in a specific company, in anticipation of a price increase, and profit only under a single condition, when the stock price moves higher. But wouldn’t it be great if you could make money regardless of which direction the market moves? With stock options you can. Smart investors understand how stock options work and how to utilize specific option strategies that allow them to profit regardless of market direction. In fact, option strategies are so diverse that they can allow investors to make money in any market condition. By trading stock options online an investor can establish a variety of aggressive or conservative equity positions. Options are versatile and can be used in a wide range of trading strategies but compose three basic functions:
- To speculate on the directional movement of a specific stock price
- To protect or insure a stock position against loss - protective put
- To increase potential profit by utilizing leverage
What Are Options
Prior to trading options, an investor must first select an options strategy that fits his or her individual goals. However, in order to select the optimal strategy, a solid understanding of how stock options work is required. Stock option contracts are divided into two categories: calls and puts. Make sure you understand how call options work before reading the remainder of this post which will discuss the second options function, specifically, how protective put options work.
How Options Work | Protective Puts
First, let's run through a simple analogy directly related to protective puts.
If you purchase homeowners or automobile insurance, your are essentially buying protective put options. These insurance policies protect you against dramatic loss if your home or car were to be damaged or destroyed by allowing you to exercise the option. For example, let’s pretend you purchase a $200,000 home and pay $1,000 per year for homeowners insurance. Regardless of whether you file a claim or not, your insurance broker keeps the premium. Basically, this is the same as an option contract. It has a strike price ($200,000), a premium ($1,000), and an expiration date (one year). After the one year contract, if nothing has happened to your home, the contract expires and you must purchase another insurance policy. Alternatively, if your home were to be destroyed by a fire, you would file a claim (exercise the put) with your insurance company which is then obligated to purchase the home for $200,000 and you receive a check. If you don’t have insurance, you save $1,000 per year in premium, but if your home is destroyed, you lose your $200,000 investment. Essentially, by purchasing insurance (protective put) you limit the risk of owning a home, however, you risk losing your $1,000 premium each year in the event your never file a claim. Buying protective put options for a position in your investment portfolio is essentially the same concept.
Hedging With Options
What Are Options | Puts Explained
A put option is contract between a buyer and a seller. The buyer of the put receives the right to sell the underlying asset (typically a stock), at the strike price, prior to the contract expiration date. Put options are basically the opposite of calls options, they make money when the underlying stock decreases. When an investor owns a specific security in his portfolio and purchases a put option on the same security he is purchasing a protective put. The put acts as an insurance policy to hedge against downside risk because if the stock price decreases the put value will increase thereby offsetting a portion of the loss. Additionally, the purchaser of the protective put has the right to sell the stock at the strike price regardless of how far the stock price falls. Therefore, by purchasing a protective put one limits the risk of owning the underlying stock but risks the cost of the premium paid to buy the contract. Just like home or auto insurance, the protective put option is purchased for protection without intention of actually using it.
Protective Put Example
During the financial crisis many wise investors purchased equities at extremely low prices. For example, let’s assume you purchased 100 shares of JPMorgan Chase & CO (JPM) on March 6, 2009 when the stock was trading $15.93/share. JPM currently trades at $44.71 and therefore you have a substantial unrealized profit. However, media coverage of a double dip recession has you nervous that the overall stock market might head lower and you are worried about losing your gains. You could sell your position in JPM, but if rumors of another financial crisis turn out to be false, and the stock continues to move higher you miss out on any further profit. Therefore, you decide to purchase a protective put in this case the January 21 2012 40 put contract for $5.70. Since the option gives the right to control 100 shares, the transaction cost must be multiplied by 100 to give a total cost of $570. The strike price of this contract is $40 and the expiration date is one year, January 2012.
- At the market close on Jan 21 2012, JPM could be trading for $50/share. In this scenario, the price of the underlying stock is greater than the strike price. Since put options increase when the stock price decreases, the option contract considered out of the money and is worthless. The investor had purchased insurance for his position which was unwarranted. This leaves him with a net profit of $2,837 (5000-1593-570). The cost of the put has actually decreased the rate of return.
- At the market close on Jan 21st 2012, JPM could be trading for $20/share. In this scenario, the price of the underlying stock is less than the strike price. This means the option is considered in the money and will be worth more than the purchase price. In this case the investor has a few options. First, he can sell the option in the open market prior to market close. The put will have an intrinsic value of $20 and be worth approximately $2,000. Secondly, he can exercise his right to sell his 100 JPM shares at $40/share. In either scenario, the investor has protected himself against a substantial loss.
In conclusion, purchasing protective puts can be an options trading strategy for investors that own current stock positions and want to protect their investment from dramatic loss. By going long a put while simultaneously owning the same security an investor retains the benefits of stock ownership such as dividend collection and voting rights. The protective put serves to limit downside loss in unrealized gains accrued since the stock was originally purchased. The put grants the investor the right to sell his shares at the strike price, regardless how far the stock price drops.
For more information on stock options check out my section on the Bull Call Spread and generating income by selling covered calls. For more advanced options methods don't forget to read how to create a synthetic long and the covered strangle and how to protect profits with a collar.
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