Refresh understanding of a put option:
Options are a contract between a seller and a buyer on what specific price they will buy or sell the underlying stock. A previous article described what a put option is. As a summary, a put option forces someone to buy stock at a set price from the buyer of the put option if that option is exercised. The desire of a put holder who chooses to exercise the option is that the price has dropped. In this case, the put holder buys stock at the current lower market price and sells it at the higher put option price to the seller of the put. Read the previous article for more details.
Holding a stock can be very scary these days.
With all of the tremendous volatility in stock prices recently, it is no longer safe to hold stock of big strong companies long term. Who ever thought GM and other large corporate stocks would return to prices not seen since the 50’s and 60’s. That means fifty years of appreciation has evaporated in only a matter of weeks.
How can I insure my stock from large losses due to big price drops?
If you own the stock of a company where you are worried about the price dropping, put options can act like an insurance policy protecting you from loss. Since the put forces the seller of the put to buy stock at a set price, you can buy a put option that has an exercise price at or near the current market price for the stock. If the current market price drops through your put option exercise price, then it makes sense to exercise the put option forcing the put seller to buy your stock at the exercise price. Alternatively, you can sell the put option at a profit to someone else before the exercise date, allowing you to continue holding your stock. Either way, the put becomes more valuable as the stock price drops, which compensates you for the associated loss in price on the stock you continue to own.
An example showing how a put option protects you from the drop in price of your stock
For this simplified example, I will not include the fees charged by your broker to trade options or stocks.
I own 100 shares of xyz corporation stock that has been going down in price lately. On October 1st the price of xyz corporation stock is trading at $50 per share. I decide to purchase a November put option with a $45 strike price that expires the third week of November. This put is trading at $2 which means I pay $200 ($2 price x 100 shares of underlying stocks) to buy the put option.
By November 15th, the price of xyz stock drops to $30 and I tell my broker to exercise the option. I then force the put seller to buy my 100 shares at $45 each for a total of $4,500 ($45 x 100). Since the stock was at $50 per share on October 1st and were sold for $45 per share on November 15th, I have limited my loss to only $5 per share ($50 October 1st price – $45 received per share = a $5 loss per share). My total loss for the 100 shares is $500 ($5 per share x 100 shares). Had I not purchased the $45 November put option, my loss would be a much higher $20 per share ($50 October 1st price – $30 November 15th price = a $20 per share loss). In that case, my loss would be $2,000 ($20 per share x 100 shares). Again, using the put option, I have limited my total loss to $500 instead of what would have been a $2,000 loss. If the stock price had dropped lower than $30 by November 15th, then the put option would have protected me from a much larger loss.
Why doesn’t every stock owner always buy put options for protection?
Put options cost money. The closer the exercise prices to current market prices, the more it will cost to buy the put option since the probability of the option “going into the money” is high. If you were to continually buy put options close to market prices, then the cost of all the put options you buy will themselves cumulatively act like a loss against your stock’s value. However, in uncertain times or before earnings or other news announcements where there is a strong possibility of bad news coming out on your stock, it may make very good sense to buy a put option. Another strategy could be to buy a way out of the money put option with a strike price far below current market prices. These type of put options will be very cheap, but you will have a much higher vulnerability to loss for the difference between current market prices and the much lower put option strike price. That strategy would be good for protection against a dramatic drop in stock price.
The use of put options is one strategy used by seasoned, sophisticated, and some accredited investors to protect their portfolio of stocks against large price drops in uncertain situations. If you own stocks and worry about price drops, consider purchasing put options as a form of insurance protecting you from large losses.
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Copyright 2008 Ole Cram. Ole Cram is President of Marcobe Investments, Inc., a corporation that invests in various oil and gas ventures and refers accredited investors, investment managers, financial advisors, investment funds, and others to the associated oil producer of these projects for their consideration to also participate. We are not licensed to sell any interest in a project, nor are we registered advisors. Feel free to email us at MarcobeInvestmentsInc@gmail.com with any questions, thoughts, or requests for other topics to cover in future articles.
This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/. Key past articles related to investments in oil and gas can be found at http://www.MarcobeInvestmentsInc.com/Oil_and_Gas_Investor_TOC.html. This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision.