If a person is going to be invested in the stock or any equity markets, they should really make sure to understand the use of options like put contracts. Put contracts are basically rights; but not obligations, to sell a specific number of shares of a stock for a specified price on a given date.
The great thing is that you do not have to own the shares specifically; but you will enjoy any gain the puts might get as a result of a drop in the stock price. Most often people use puts as protection for their investments. A prime example would be when an individual or entity owns several stocks within their portfolio that have good financial gains over a period of time.
If the individual or entity does not wish to sell their equities, but wants to protect their gains, they could use puts to do so. They could buy these puts against an exchange traded fund that closely mirrors their holdings.
The end result would be that if there was a sharp downturn in the market, the individual stocks would decrease in value, but the put option would increase in value, offsetting the loss. Before starting to get into specifics though, one should understand the basic elements of a put.
Much like a call, the basic elements of a put are the expiration date and the strike price. The expiration date is the date that the actual contract runs out. Most put contracts expire monthly, but with the recent introduction of weekly contracts, one has to be careful as to which one they purchase.
The strike price is the price that is guaranteed by the contract. For example, if one buys a put with a strike price of $5; then if the price of the stock is below that mark, the put contract will be worth the difference of the strike price less the closing price of the stock.
So if the stock in question was to close at $4 on the expiration day; and the put’s strike price was $5, then the ending value of the put would be $1.
The purchaser of the put has pretty much ensured that the value of the investment will not drop any lower than the $5 mark. So let’s see an example of how this is done.
Let’s say an individual buys 100 shares of a company for $10 a share. Over a period of time, the stock appreciates to $20 a share, which would be a $10 profit for each share. The owner would like to protect their $10 profit, but they do not want to sell the stock. They would like to recognize more upside if possible.
They decide to buy a put contract that expires in two months at the $20 strike price. For this insurance policy, they pay $100 for a single put. If in two months the stock price were to continue to go up, the put would expire worthless; and the purchaser would be out the amount; they paid for the put but that would more than be offset by the increase in the stock price.
If the stock was too dramatically fall in value back to the original $10 price, the owner of the put would be protected.
Since the put was purchased at the $20 strike price; the owner would be able to sell his shares for the $20 price. They would still be out the original $100, they paid for the put but would pocket the difference. If the put had not been purchased; the owner would have lost all of their profits; and the value of their investment would be back at the original cost.
In conclusion, one can see that by using put options, they can protect one’s investment portfolio. If there is volatility in the financial markets, trying to protect your investments will prove hard to do. By becoming knowledgeable in the options markets; one can learn to protect their gains and limit their losses in a hard economic environment.