Let’s say, you buy a car costing RM 50,000.
In relation to this, you insure the car for RM 48,000 for 1 year. Its insurance premium is RM 900.
One year later, if the car remains intact, the insurance policy would expire. Its premium would be “burned”.
However, in that one year period, if the car is critically damaged, the insurance company will pay out RM 48,000 to you in compensation. Sure, you lose the car. But hey, you did not suffer a total loss. Rather, the loss is limited to just RM 2,000.
What is a Put Option?
A put option works like our car insurance policies. It is the same mechanics applied onto stocks.
Instead of the car, the asset (to be insured) is the stock, let’s say A Inc.
Instead of car damage, the risk to be covered is falling stock price.
Instead of a sum assured (RM 48,000), you can determine its strike price.
There is a contract duration and there is a premium to pay for it.
How Does It Work for Investors?
Let’s say I’m interested in investing and keeping A Inc’ shares for the long-term.
This is because A Inc is fundamentally a strong company and its price is attractively valued. The price now is $50 a share and thus, I invest $5,000 to buy 100 shares in A Inc.
Although I intend to hold onto its shares for the long run, the markets could remain volatile in the next 12 months due to elections and geopolitical uncertainties. What if A Inc falls to $40 a share, resulting from such uncertainties?
Sure, I can continue to keep 100 shares in A Inc in that situation as I’m in it for the long-term.
But this means that the total value of my holdings would drop from $5,000 to $4,000.
To protect my net worth (risk to be insured), I can buy an insurance policy against it (put option).
I can buy a put option. The contract is for a year. In that period, if its price drops below $50, I will have the option to sell A Inc’s at $48 a share. For instance, if its price falls to $40 a share, then, I could exercise this put option by buying another 100 shares (1 option = 100 shares) at $40 each and sell it off immediately at $48 each.
With that, I’ll be compensated $800 ($8 each share x 100 shares) less its premium.
As a result, I’m still holding onto my 100 shares in A Inc at $4,000 in investment value. Such is a temporary capital loss of $1,000 (It’s temporary because I haven’t sold off my shares). However, as I received $800 less premium from my put option (insurance policy), my total capital loss was effectively limited to just $200 + premium.
Effectively, I had preserved $800 less premium in capital loss.
But What If A Inc Rises Above $50?
Then, the premium paid for the put option (insurance policy) will be burned totally.
So, let’s assume that A Inc rises up to $60 a share.
In this case, my investment value for A Inc shall rise to $6,000. That’s great. My temporary gains (capital gain) would be $1,000 – premium.
Difference between Call and Put Option
To investors, both call option and put option are insurance policies.
Call option is an insurance policy that covers the risk of stock prices rising up too quickly. With it, investors would buy call option contracts as a way to lock in the maximum future prices that they like to pay for their preferred stocks.
Put option is an insurance policy that covers the risk of stock prices falling down too quickly. The policy could add some form of security in ensuring that you may recover back some capital loss, which was caused by external market factors or even personal investing mistakes.
Conclusion:
The above offers a simple illustration of what a put option is.
Next, we’ll discuss why instead of buying, some of us may choose to sell both call & put options.
