- April 2, 2018
- Posted by: fortunatetrader
- Category: Trading 101
What is a Call option and a Put option and how does it work? — Part2 – Buying a PUT
Make sure you understand what the options are first: What is an Option?
Welcome to the second article of the series.
We learned in the last article What is a Call option and a Put option and how does it work? – Part1 – Buying a CALL that there were two different kinds of options: CALLs and PUTs.
We also learned what the four possible actions to do with options were:
-BUY a CALL
-BUY a PUT
-SELL a CALL
-SELL a PUT
When you buy a CALL option you have the right to buy the stock (or underlying) when you want during a define period. “Got it.”
But what if I’m buying a PUT?
What is buying a PUT option?
Buying a PUT option is having the right to SELL something to someone at a defined price during a specific amount of time.
As a buyer of a PUT you expect the underlying asset to drop below the defined price before the expiration date.
Do you drive a car?
Did you know that you have been buying PUT options since you have started to be insured?
Let’s say you own a 2018 Audi RS 7 Sportback Performance which has a listing price of $100 000. You might want to put insurance on that baby. Using a super easy number, it costs you $100 per month to get the insurance, “bumper to bumper”.
You are signing a contract with the insurance company that is going to provide you the service of insuring your sport car.
What you are saying to the insurance company (seller) is: “I’m giving you my $100, so if I get in an accident or do any kind of damage and the car goes to a total loss, during this month, you still have to buy the car from me if I tell you so.”
So what will happen if the $100 000 goes to $0? they are forced to honor their obligation because you have an insurance policy, called here a PUT option contract, to pay you the total value of the car, $100 000.
What’s in it for you?
You get protection from loss and you can force the insurance company to buy it in case you do get in an accident.
What’s in it for them?
They receive $100 a month and if you don’t get in an accident they get to do the deal over and over again.
That is buying a PUT option.
Why buying a PUT option in the stock market?
You can buy yourself protection, like the car example, or bet that the market will plunge and you will be able to sell your contract on to someone else. We will cover this part later.
In brief, you think that the market will go down; that the market will be bearish. That’s why you’re buying a PUT option contract.
Do you remember the example of the house at $100 000 that increased in value to $150 000?
Let’s use the same analogy.
The only difference here is that I already own the house worth $150 000.
I buy a PUT option for my house because, now I think that the market in the neighborhood will go down.
It costs me $1 000 right now to have the RIGHT to SELL it to someone in the next year.
So after a year if the market drops the price of the house to $90 000 because there were three criminal incidents during that period, that option is still open.
You then exercise your RIGHT and force the WRITER to buy your house at the discussed price of $150 000 a year ago. Well done cowboy!
“But what if the house market stays the same or worse still, goes up in price and the house gets to $200 000 instead of going down?”
If that occurs, you mightn’t want to exercise your RIGHT.
Why sell something at 150K that is now worth 200K?
You might want to just let the contract expire and sell it at the actual market price.
Remember? We had settled the contract period for a year.
You will have lost your $1 000 but you won’t have sold something that is worth more, or what we call “Out of the money” for a PUT buyer.
Today we have learned about one of the four ways of trading options: buying a PUT option.
In short, a PUT option is called a “PUT” because the owner has the right to “put the stock away” from the seller. It is also called an option because the owner of the contract has the RIGHT, but not the OBLIGATION, to SELL the stock at the strike price. In other words, the owner does not have to exercise the option and sell the stock. If selling the stock at the defined price is unprofitable for him, the owner of the PUT can just wait the predetermined timeframe and let the option expire, worthless.
– Make It Happen –