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Everyday Options, Part 2

Russ Allen

This is the second in a series of introductory articles on trading stock options for profit. It is aimed at people who are not familiar with options. The intent is to explain stock options by comparing them to everyday items, to make them easy to understand.

In our last article, we described one of the two types of stock options, the Call option, as being similar to a sale coupon.

Today we’ll look at the second and last type of option, which is referred to as the Put option.

Very briefly, a put option is like an insurance policy. It insures the holder of a stock against a drop in the value of that stock.

Think of a truck that is worth $10,000. Obviously, we are talking about a used truck, although that’s not important. $10,000 is just a nice round number.

The owner of the truck wants to be protected against its losing value in the event of a collision. He accomplishes this by buying an insurance policy. He is very risk-averse, so he buys a zero-deductible policy. If his truck is damaged in a collision, the insurance company will pay him enough to make him whole. If the truck is a total loss, the insurance company will pay him the full $10,000.

Put options are a lot like car insurance.

The insurance policy is good for a set period of time, say six months. The owner must pay the premium for that policy. Let’s say that is $680.

For the period that the policy is in force, the insurance company will pay for any damage to the truck. IF it is totaled, the company will buy the worthless truck from the owner for the policy amount of $10,000. If there has been no damage to the truck, there will be no need to file any claims on the policy.

At the end of the six months, the policy expires. If after the policy’s expiration the owner wants to continue to be protected, he will then have to buy another insurance policy, and so on.

The truck owner had other alternatives – other options. He could have decided not to insure the truck against collision damage. He could have saved the $680 in that way, but would have had no protection.

He could also have opted to save money on the insurance by buying a cheaper policy with less protection. A policy with a $500 deductible instead of a zero deductible would have been less expensive – the six-month premium might have been $485 instead of $680.

Now, let’s look at a Put option on a stock to see the parallels with the truck’s insurance policy.

We’re going to call our stock PQR (just because XYZ is so overused). It is currently trading at $100 a share. A hundred shares of that stock would be worth $10,000. There are Put options offered for that stock that expire in about six months. To protect the full $100 per share value ($10,000 total), the price of a put is currently $680 – like the $10,000 truck insurance policy. The Put, once it’s been paid for, gives the person who bought it the right to sell the PQR stock for the full $10,000 at any time they want during the six-month lifetime of the put. They just have to call their stockbroker and say, “Exercise my PQR puts.” The PQR stock will be removed from their brokerage account, and $10,000 in cash will be deposited in it.

This means that if during that time the stock goes down to, say $9,000, the put owner can exercise the put and thereby sell the stock for the full $10,000.

In the event of a catastrophic crash, PQR stock might become completely worthless – its value might be zero. The stock will have been “totaled.” Even in that event, the puts can be exercised and the full $10,000 recovered.

The party responsible for providing that $10,000 is the seller of the put. They have taken on the role of the insurance company. They have accepted the premium (the $680 put price). They are now obligated to buy the stock for the full $10,000 whenever they are ordered to by the put owner.

The put seller hopes that will never happen. And it won’t if the PQR stock stays above $100 per share. There is no need to “file a claim” – exercise the put – if there has been no loss. If the put is not exercised by the time it expires, then the put seller keeps the $680 premium as clear profit.

The put seller’s motivation for selling the put is like that of any insurance company. They intend to take in as much as possible in premiums, and pay out less in claims than the premiums collected. If they sell many policies, and have only a few claims, they will profit in the long run.

The stock owner could also have chosen to buy a cheaper put, if he were willing to accept a lesser amount of protection. A put that would pay $9500 instead of the full $10,000 could be bought for $485 instead of $680. This is like the truck owner buying a policy with a $500 deductible instead of a zero deductible, for $485 instead of $680.

So, here in summary is how the PQR put is like the truck insurance policy.

The put buyer (the truck insurance buyer) protects the value of an underlying asset with a $10,000 value – PQR stock, which corresponds to the $10,000 truck. The put buyer pays the premium of $680 for the put, like the insurance buyer pays the $680 premium for the policy.

The put buyer now has the right to exercise the option when he wishes, like the truck owner has the right to file a claim whenever his truck has been damaged. In both cases, the protection lasts for a fixed period of time – that is, until the expiration date.

The last wrinkle is this – anyone can buy puts on the PQR stock, whether they own any PQR stock or not. If a put buyer does not own any PQR stock, they are called a speculative put buyer. The put sellers are happy to sell puts to all comers, no questions asked.

Free Trading WorkshopThat means that someone who believes the price of PQR will go down, can buy puts in order to profit from that drop in price. They can pay $680 for a 6-month option to sell the stock for $10,000. If the stock then does go down to $9,000, that person can go buy the stock for $9,000 in the open market. They can then exercise their put, turning over the stock they just bought for $9,000, and being paid $10,000 for it – a $1,000 gross profit.

After subtracting the cost of the put, the speculative put buyer would have a profit on the entire transaction of $1,000 – $680, or $320. If the cost of the stock had gone down by $2,000 instead of $1,000, then the put buyer would have made a thousand dollars more. Best case for the speculative put buyer is that PQR becomes worthless. They could then get the stock for nothing, and sell it for $10,000. The put seller is on the hook for that $10,000 regardless, and is required to have enough reserves to pay it.

So, the put option on a stock is very much like an insurance policy that anyone can buy. It can be used by someone who does own that stock to protect the value of it – to limit risk – exactly like truck insurance.

Or the put option can be used by someone who does not own that stock as a bearish speculation with limited risk. Worst case, the speculative put buyer loses the premium paid, which is a small fraction of the value of the asset. Best case, the speculation pays off in a big way.

Either way, the put sellers behave like insurance companies, collecting premiums and, hopefully for them, not paying out claims. Tweet: Put sellers behave like insurance companies, collecting premiums and hopefully not paying out claims. //

This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.