A put option on a stock is like an insurance policy in that it requires payment of a premium; and once the premium is paid, the owner of the put option has the right to recover a certain value from the stock even if its market price goes down dramatically.
Buying a Put Option as Insurance
In our earlier example, an owner of 100 shares of a $100 stock paid $4.85 per share to buy a put that insured that he could recover at least $95 per share if the stock’s market value went down. This is true even if it went all the way to zero. It was very much like a $5-deductible insurance policy. The stock owner would have to absorb up to $5 per share in losses if the stock went down. But if it went down further than that, he would have no further losses. Buying the put option allowed him to know and limit his maximum loss.
To “make a claim” on that put, he would call his broker and order him to exercise the put. The broker would then remove the stock from the investor’s account and put in $95 times 100 shares, or $9500. The source of that $9500 would be the person who sold the put. That person was acting as the insurance company and was required to have the money in reserve.
Why Buy a Put Option When You Don’t Own Stock?
Well, in that case, buying a put option is a bearish speculation. Let’s say that I see that stock ABC is now selling for $80, and I believe its price will drop to $70 within three months, a drop I’d like to profit from. I could sell the stock short but that would involve unlimited risk in the event that the stock zoomed upward (for example if the company received a takeover bid). But for a small fraction of the stock price, say $3 per share, I can buy a put option on that stock which gives me the right to sell it for $80 a share for six months.
If I’m right and the stock does drop to $70 (before the put expires), I can now cash in. I can do this in one of two ways:
First, I could buy 100 shares of stock at the market price of $70; and then exercise my put option. Exercising the put takes the stock back out of my account and puts $80 per share in cash into it. I have a gross profit of $10 per share, and a net profit of $7 per share after deducting the $3 cost of the put.
Alternatively, I could realize that $10 without ever buying the shares at all. The put option I own is freely transferable. I can sell it through my broker’s online trading platform with a few mouse clicks. Because anyone who owns the put can exercise it, the put is always worth at least the amount of gross profit incorporated in it – in this case $10. If it still has time left on the clock, during which the stock could drop even more, then the put will be even more valuable than that $10 built-in profit.
I can simply sell the put option that I own at its market price of $10 or more, and pocket my $7 net profit in that way.
By buying the put option, I made a trade that could pay off very nicely if I was right about the stock dropping; and yet would have a limited loss of only $3 per share at worst if the stock did not drop.
This ability to do a leveraged speculation, where the lever works for you but not against you, is one of the main attractions of options. They have other uses too, covered in previous articles. If you’ve never tried trading them, look into it!