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Written by Jin Won Choi on Feb. Last update on March 27, Then 2 weeks ago, I explained what call options are. In this post, I will explain another variety of options called 'put options'. As I did last time, I'll not only explain what they are, but how to think about such options. But before I begin, I want to again give a big word of caution. Options are complex financial instruments. Using options is kind of like using dynamite - useful, but dangerous to a beginner.
Don't dabble in it unless you really now what you're doing. Let me first explain what put options are. Holding a put option gives you the right to sell a stock at a fixed price. This fixed price is called the 'strike', and the prices of put options differ for various strikes. As with call options, put options also have expiries.
The price of the put option again differs for various expiries. To put it one way, put options are the opposite of call options that we explored last time. Whereas call options give the holder to right to buy at a fixed price, put options give the seller the right to sell at a fixed price. You make money on put options when the stock price goes down. On the other hand, if the stock price ends up above the strike, then the put option becomes worthless.
This last fact means that you can lose every penny you put into buying put options. In fact, this routinely happens. For this reason, buying put options is dangerous business. If call options can be thought of as borrowing money to buy stock, put options can be thought of as insurance. If you buy house insurance, you pay out a monthly premium. As long as your house doesn't burn down, you don't benefit from having the insurance. You eat the premium you paid as a loss. However, if your house does burn down, you gain above and beyond what you paid for in premiums.
Now, suppose you own shares of GE. You hold GE stock because you believe in the company. However, you're a little nervous about what's going to happen to the stock in the short term.
To alleviate your anxiety, you can buy put options. In effect, this limits the extent of your loss to just the amount you paid for the put options - i. Also, like insurance, if the bad news never comes and GE goes up, you don't gain anything from having insurance. You'll just have eaten the insurance premium as a loss. While put options and insurance are very similar, they do have one difference. Whereas you can only buy insurance on what you already own, you can buy put options on stocks you don't own.
In other words, I don't need to own GE stocks to be able to buy put options. If I buy put options on GE without owning the stock, it becomes a gamble that GE stock will fall in the future.
This is like buying insurance on your neighbour's house, because you think they carelessly play with fire all the time.
So when does it become worthwhile to purchase put options? Whether you're wanting to insure parts of your portfolio, or bet against a specific company, it really comes down to one thing: Sometimes, the market offers a low price for the options i. Sometimes, the markets offer a high price for the options i. Buying options only make sense when options prices are low.
So how do we know whether option prices are hight or low? That's the topic of the next article of this series, so stay tuned. If you buy put options, it's as if you bought insurance against a stock falling out of bed. If the stock does fall out of bed, you make money on the put option. If not, the option becomes worthless, and you lose what you paid for the option. If you buy put options on stock you already own, the options act as a safety net.
However, you can also buy put options on stock you don't own, and if you do that, it becomes a bet that the stock in question will fall.
Whether it makes sense to buy put options depends on the price you pay, and we'll look at how to value such options in the next article in this series. If you enjoyed this article, you might be interested in our free newsletter. Enter your email to get free updates. Choi is the founder of MoneyGeek. He has a PhD in financial mathematics, and he worked at a top performing fund for 2 years.
You can think of put options as a form of insurance. What Put Options Are Let me first explain what put options are. Betting Against A Stock While put options and insurance are very similar, they do have one difference. Summary I've crammed a lot of information on this page, so let me summarize it. Choi's commentary on current financial events All this is available for free. Join others and subscribe using the box below.