An Explanation of Put Options

One of the most difficult things about learning how to trade options comes down to understanding the terminology. It can take quite some time to grasp the basic concepts of options trading. Once these basics are learned, then you can increase the sophistication and use of options so that different goals may be accomplished. The put option is one of the two types of options contracts upon which all other types of trades are made. The call is the other basic building block, but that will be discussed in another article.

The put option is a contract between two parties. One of the parties sells the put option. The other party buys the put option. A put option allows the buyer of the contract the opportunity to force the seller to take stock (or whatever the contract states, but we will only be discussing stock) at a specific price on or before a specific date. The seller is obligated to take that stock and live up to the terms of the contract no matter what. The buyer has opportunity while the seller has obligation. Let’s look at a specific example to make it easier to understand.

Apple is the maker of the ipod.  It is a publicly traded company upon which option contracts are offered.  Not every company has option contracts available but most of the bigger companies do.  Apple (ticker symbol AAPL) closed yesterday on the stock market at $185.02 per share.  Let’s say that I own 1000 shares of AAPL in my brokerage account but I was concerned that AAPL may not sell many ipods or iphones this Christmas because of the economy.  I want to keep owning the stock, but I am concerned that in the near-term (next 3-6 months), the stock may not do well.  Of course, I can never be sure what the price of a stock will do but I want some protection.

Therefore, I decide to buy some put options for protection of my AAPL stock (like an insurance policy).  If I go to my online broker’s website and click on the options chain for AAPL, I see that the $185 strike January 2010 put option will cost me $15.35 per share.

Timeout for some definitions:

• Options chain—a listing of all the available options (both calls and puts) on a given stock with all the different strike prices and expiration dates
• Strike price—the agreed upon price for that options contract. In our example, the strike is $185
• Expiration—the time that the option expires. All contracts expire on the 3^rd Saturday of the month (but the last trading day in the day before on Friday). After that, whatever you have is what you have (like hot potato). Our AAPL put would expire in January 2010
• Premium—the cost of the contract. The buyer pays the premium, and the seller receives the premium just like insurance. In our case, the quotations for the put option price the premium at $15.35 per share of AAPL stock. Most options contracts are for 100 shares of stock.

Back to the example:

I decide that I am concerned enough that I am willing to pay to buy 10 put contracts which will cover all 1000 shares of AAPL stock that I own. I pay the total premium of $15,350 to protect my $185,020 investment. That seems like a lot of money and maybe it is. But maybe it isn’t.

If Apple has a wonderful holiday season and earnings are great, the stock may go up to $250 per share. Yippee! I made a lot of profit on my stock. Not as much as someone who didn’t pay the premium to buy put options, but some (plus I slept fine not worrying about my investment). If AAPL does so-so and ends at $185 in January, then it seems like my premium was wasted (but I slept fine). However, if I am right and Apple does not many products at all and the stock craters to $90 per share, guess what? I don’t even have to wait until the third Saturday in January. I call my broker on the day after Christmas and say that I want to exercise my put contracts. Then the seller of the puts is forced to buy all my AAPL stock from me at $185 per share. I take my $185,000 and invest elsewhere.

There are other more sophisticated uses for puts which you can read about here, but the one just described is the most basic. It is a protective put and is designed to protect your portfolio from calamity just like insurance. The reason I only lost 18.2% on my retirement accounts last year was because I own puts on every stock that I own. I wouldn’t think about not owning insurance on my house nor would I think about not owning insurance on my stock investments. It did what it was designed to do. The puts protected me from financial calamity when one of my stocks dropped over 80% and allowed me to sleep at night. I was not forced to sell at the bottom because I knew my loss was limited.

Some generalizations about options contracts are in order:

• The greater the volatility of the stock you want to protect, the higher the premium. Makes sense, just like hurricane insurance costs more in Florida, than in Denver.
• The longer the contract, the more the premium. Again it makes sense. A two year contract costs more than a one month contract.
• The higher the strike for puts, the more the premium is. If I didn’t want to spend as much money for my insurance, I could assume more risk myself and increase my deductible. For my AAPL puts, that could mean buying the $175 strike price instead for $10.85 per share.

Options can be difficult to understand at first. I would suggest learning them from one side first (as a buyer) and then going through the different scenarios as I did earlier. What would happen if the stock went up a lot, what happens if the stock goes down a lot, and what happens if there is no change? How does that affect me as the buyer of the option? This goes a long way to helping understanding. Then read some of my other articles about options and feel free to ask questions. I am happy to help.