Put Options Explained Using Examples

Last update on March 27, 2014.

Fire insurance

Fire insurance: You can think of put options as a form of insurance.

 

In the last episode of My TFSA Update, I said that I plan on buying options in the coming months. Then 2 weeks ago, I explained what call options are. In this post, I will explain another variety of options called 'put options'. As I did last time, I'll not only explain what they are, but how to think about such options.

But before I begin, I want to again give a big word of caution. Options are complex financial instruments. Using options is kind of like using dynamite - useful, but dangerous to a beginner. Don't dabble in it unless you really now what you're doing.

What Put Options Are

Let me first explain what put options are. Holding a put option gives you the right to sell a stock at a fixed price. For example, I can buy a put option on GE stock that gives me the right to sell GE stock for $25. Or, if I'd like, I can buy a put option on GE stock that gives me the right to sell at $30 a share. This fixed price is called the 'strike', and the prices of put options differ for various strikes.

As with call options, put options also have expiries. For example, I can buy a put option on GE with a strike of $25 that expires on June 2014, or I can buy one that expires on Jan 2015. The price of the put option again differs for various expiries.

To put it one way, put options are the opposite of call options that we explored last time. Whereas call options give the holder to right to buy at a fixed price, put options give the seller the right to sell at a fixed price.

You make money on put options when the stock price goes down. For example, let's say you held a put option on GE with a strike of $25 that expires on June 2014. Let's say that on June 2014, GE prices went down to $20. Then, you can buy a GE stock for $20 in the open market, and then exercise the option to sell it at $25. That's a $5 profit per option.

On the other hand, if the stock price ends up above the strike, then the put option becomes worthless. For example, if GE sock goes to $26, then the option with a strike of $25 becomes worthless. Why? Because even if you held GE stocks now, you wouldn't sell it at $25 by exercising the option, when you can sell it at $26 in the open market.

This last fact means that you can lose every penny you put into buying put options. In fact, this routinely happens. For this reason, buying put options is dangerous business.

Put Options = Insurance. Sort of.

If call options can be thought of as borrowing money to buy stock, put options can be thought of as insurance. Let me explain.

If you buy house insurance, you pay out a monthly premium. As long as your house doesn't burn down, you don't benefit from having the insurance. You eat the premium you paid as a loss. However, if your house does burn down, you gain above and beyond what you paid for in premiums.

Now, suppose you own 100 shares of GE. You hold GE stock because you believe in the company. However, you're a little nervous about what's going to happen to the stock in the short term. To alleviate your anxiety, you can buy put options.

As of this writing, you can buy put options on GE with a strike of $25 and an expiry of Jun 2014 for $1.6 each. This means that if you buy 100 such options for $160 total, you can guarantee that you can sell all your GE shares for $2,500. Even if catastrophe strikes and GE prices go down to $20 or even $10 a share, you can exercise your put options to sell your shares for $2,500.

In effect, this limits the extent of your loss to just the amount you paid for the put options - i.e. the $160. In other words, it's as if put options are insurance against the stock falling out of bed, and the $1.6 per option paid is the insurance premium.

Also, like insurance, if the bad news never comes and GE goes up, you don't gain anything from having insurance. You'll just have eaten the insurance premium as a loss.

Betting Against A Stock

While put options and insurance are very similar, they do have one difference. Whereas you can only buy insurance on what you already own, you can buy put options on stocks you don't own.

In other words, I don't need to own GE stocks to be able to buy put options. If I buy put options on GE without owning the stock, it becomes a gamble that GE stock will fall in the future. This is like buying insurance on your neighbour's house, because you think they carelessly play with fire all the time.

So when does it become worthwhile to purchase put options? Whether you're wanting to insure parts of your portfolio, or bet against a specific company, it really comes down to one thing: the insurance premium (i.e. cost of the options).

Sometimes, the market offers a low price for the options (i.e. a low premium). Sometimes, the markets offer a high price for the options (i.e. a high premium). Buying options only make sense when options prices are low.

So how do we know whether option prices are hight or low? That's the topic of the next article of this series, so stay tuned.

Summary

I've crammed a lot of information on this page, so let me summarize it.

If you buy put options, it's as if you bought insurance against a stock falling out of bed. If the stock does fall out of bed, you make money on the put option. If not, the option becomes worthless, and you lose what you paid for the option.

If you buy put options on stock you already own, the options act as a safety net. However, you can also buy put options on stock you don't own, and if you do that, it becomes a bet that the stock in question will fall.

Whether it makes sense to buy put options depends on the price you pay, and we'll look at how to value such options in the next article in this series.

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