PUTs

Purchasing a PUT option on a stock gives the buyer the Option (But not the obligation) to sell a set stock at a set price until a set date.

Puts can be used as insurance against the price of stock you hold falling in price. If you bought some shares on a stock and they went up in price by purchasing a put option on the stock at the new price you have in effect locked in the price rise of the shares.

Options for laymen

I believe the analogy of a house purchase is one of the best ways to explain how an option works so I will use that basic premise here.

The cash values are only for simplification and this will obviously work for different options and stock prices.

Case Study: Buying a Put Option on a house

We have a house that is currently selling for $100,000.

We think the house prices may fall but do not want to sell the house this month, we approach a purchaser with a Contract (proposal).

Our Contract states that we will give the purchaser $1000 dollars for the option (the right but not the obligation) to sell the house at the list price of $100,000.

The contract is valid for 30 days and if we do not sell the house within that period the purchaser will keep the $1000 and there is no further commitment on either of our behalf.

We have in fact purchased the equivalent of a one month Put option on the property.

The contract is valid for 30 days and if we do not sell the house within that period the purchaser will keep the $1000 and there is no further commitment on either of our behalf.

We have in fact purchased the equivalent of a one month Put option on the property.

o If the housing market soars (in the next 30 days) and the house is now valued at $110,000 we let our option expire worthless and we can sell the house for $110,000.

$110,000 (Current Value) – $1000 (Option Price) – $100,000 (Initial Price) = $9000 (Our Profits).

o If the housing market crashes (in the next 30 days) and the house is now valued at $90,000 we can exercise our option and sell the house for $100,000.

$100,000 (Sale Price) – $1000 (Option Price) – $90,000 (Current Value) = $9000 (Our locked in value).

Contract Sizes

On the Australian Stock Exchange a standard Put Contract usually covers one thousand underlying shares (some contracts have odd numbers so be aware of the quantity of the underlying stock the option contract covers).

On the New York Stock Exchange a standard Put contract usually covers one hundred underlying shares.