Put Options 101
You may already know that a call option is a contract that gives the holder the right, but not the obligation, to buy something at a certain price within a certain amount of time. A put option is similar in form and structure with the major difference being that it gives the holder the right to sell something at a certain price, within a certain amount of time. Put options allow the holder the opportunity to profit from a decline in price of the underlying asset or hedge a position held in an underlying asset.
Suppose we believe Company ABCs stock is about to drop. Its latest product has been recalled and the largest competitor is stealing customers. ABCs stock currently trades at $20 per share. The January $20 puts trade at $2. If you spent $2000, you could buy 1000 puts. If the stock dropped to $10, your puts would be worth around $10 give or take a dollar depending on how close they are to expiring. In other words, your $2000 investment is now worth $10,000. Not bad.
Now suppose you bought 1000 shares of ABC at $20 per share. You're concerned that the stock may drop so you buy 1000 puts at $2 each. If the stock drops, you still retain the right to sell the stock at $20 regardless of how much its price drops. The most you lose is the $2 premium you paid for the put. In other words, $2 bought you insurance against a decline in price. Put options can be a compelling way to profit from downward pricing movements or hedge positions. But be careful. If nothing happens and they expire, you've lost your premium.
Reuben Advani is the president of The BARBRI Financial Skills Institute and the author of two finance books. More information on this and other topics can be found at http://legalpractice.barbri.com.