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In a recent article, we discussed the structure of what’s known as the call option. As we discussed, call options are essentially contracts to purchase a certain number of shares of a stock at a certain price, within a certain amount of time. When the price of the stock increases, the value of the call option generally increases as well. We saw that the advantage of holding a call option is that it allows you to capture the upside of a stock’s upward movement with less capital and minimal downside. So what if we believe that a company’s stock price is going down? How can we protect ourselves or, profit from this downward movement? We buy a put option. Put options, like call options, are contracts that allow the holder to profit from the movement in an underlying stock (or other security).

Let’s imagine that our favorite company, Bailout Industries, has fallen on hard times. Its stock is trading at $10/share and you believe it could drop to as low as $5/share in the next year. You currently own 100 shares of Bailout stock and are concerned that if you hold on to it, you could lose half your investment. In order to protect this position, you buy put options. The December 2010 $10 put option is currently selling for $2. In other words, a contract to sell one share of stock at $10 before December of 2010 is priced at $2. If the stock drops to $5, your put option will appreciate in value. At expiration, it will be worth $5 (the $10 you would sell it for minus the market price at that time). So while you lost value on the stock position, you gained value on the put option position. The put option was essentially an insurance policy against a drop in stock price.

The problem with put options is that if the stock price stays flat over the next year, you would lose the $2 premium that you paid for the option. In other words, you had to pay the equivalent of 20 percent of your position just to protect it! For some, giving up something to have this kind of protection is well worth it. Of course, to break even, their stock will now have to appreciate by 20 percent.

Learn more about these and other useful concepts at our many upcoming webinars, local seminars, and on-demand programs.

This entry was posted on Thursday, September 2nd, 2010 at 9:06 pm by Reuben Advani and is filed under Markets, Valuation. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.