Sunday, April 17, 2011

The Unintelligent Investor's Definition of the Week: Put Option

Hey there,


Definition from Oxford Dictionary:
Noun, a right to buy or sell a particular thing at a specified price within a set time.

Definition from The Free Dictionary:
The exclusive right, usually obtained for a few, to buy or sell something within a specified time at a set price.
(Business/ Commerce) an exclusive opportunity, usually for a limited period, to buy something at a future date
(Economics, Accounting & Finance/ Stock Exchange) Commerce the right to buy (call option) or sell (put option) a fixed quantitiy of a commodity, security, foreign exchange, etc., at a fixed price at a specified date in the future.

Last week I wrote about buying call options which gives you the right but not the obligation to buy a stock at a certain price for a certain amount of time. As promised, today I’ll write about buying put options.

So buying put options are sorta similar to buying a call option but instead of getting the right to buy, you get the right to sell.

If you buy a put option, you buy the RIGHT but not the OBLIGATION to sell an asset as a fixed price at a fixed date.

So if you bought a call option, you’ll want the price to go up because that gives you a profit. However, if you buy a put option, you want the price to go down in order to make a profit. When might a call option be useful? Look at the BHP chart below.

It has been trending slowly upwards for the past 6 months. You have shares in BHP and what if you want to cash your profit but at the same time not want to miss the opportunity to make more if it continues to trend upwards?

You buy a put option. So you pay a premium and get the right to sell BHP at 47.53 dollars with an expiry date of lets say, 6 months. So if in 6 months, if the price drops below 47.53 dollars, say 20 dollars, you would exercise your right to sell the shares at your strike price and make a healthy profit. On the other hand, if the price of BHP keeps going up, you will let your option expire; losing the premium you paid but still owning the shares.

If we draw pay off a diagram for buying put options like we did for call options, this is how it will look like.

With these examples and illustrations, I hope you can see why options are sometimes used to hedge a portfolio. For example, if you buy a call option, you protect yourself from losing too much in case a share price drops below the purchase price. Whereas if you bought a put option, you lock in your profit in case the share price drops below the current level and at the same time allow yourself to make more if it keeps going up.

Thanks for reading, I hope it has been helpful, if you are confused, I recommend reading last weeks’s post for the explanation of options. Click on the little like icon on the right side of the screen to like the page on facebook or follow me on twitter. Thank you!

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