Why Buy a Put Option?

Put options are a fantastic way to insure your portfolio.

By Jason Fittler

Buying an option is buying the right to take some sort of action. You use them in the share market to increase leverage and reduce risk.

A Put option gives you the right to sell a share at a certain price, by a certain time. This allows you to outlay a small amount of money now but at the same time provide you with the benefit of locking in the price you can sell your share. Your risk is the cost of the option.

Example: You want to hold your existing holding of 1000 shares in XYZ. Current price is $10. But you are concerned that the price of the stock may fall. To lock in the current price of XYZ now and make sure that you are protected from any fall in the price of XYZ, you purchase the right to sell XYZ for $10 in six months using a Put option; this costs you $1 per option or $1000.

Investors do this for a number of reasons, to protect their portfolio from downside risk if they think the market is falling, to reduce transaction costs, to prevent incurring capital gains or to speculate on the market.

If after 6 months the value of XYZ has fallen to $5.00 per share, the price of your Put option will now be worth $6.00 per option. When you entered the Put position your shares were worth $10,000 and your Put cost you $1000. Your total investment was $11,000. Six months later the shares are worth $5,000 and the Put is worth $6,000, so value is still $11,000.

As you can see from the above example you have had a zero sum gain, you have protected your position against a fall in the price of XYZ. If you did nothing, you would have lost $5000 on the shares. So in essence, by buying a Put option you can insure your portfolio against falls in the price.

What would also be apparent to some of you is that you could use Put options to speculate on downward movements in the market. Indeed many traders do. But keep in mind, with options you have to get the direction of the market correct as well as the time in which this will happen. As there are two factors affecting your return, the risk of trading options is higher and therefore should be done with the help of professionals.

Risks

With options you need to get two things right, the movement of the shares, with a Call option the price of the share needs to move up. Second you also need to get the timing right, in the above example you have 6 months for the stock to move up. Longer then this and you lose the value of the option.

Leverage, when you gear you get better returns and bigger losses.

In the above example, if you purchased $10,000 worth of Call options in XYZ and the price moved down 10% you would lose all of your money. If you purchased the shares you would lose $1000.

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