Puts, the Stock Options Insurance Policy!

So why would you buy a put option? One reason is for insurance against possible losses in stock you already own. You use it very similar to how you use house, car, or even life insurance, because life really doesn't offer any real guarantees. For the purposes of this article I use Xyz Company because it is not a real company.

Hypothetical Situation

You own the stock in XYZ Company and you want to protect your interests in the stock just like you want to protect yourself from huge losses on your car from accidents. Let's say you heard that XYZ Companies stock that you own is probably going to go down in value because their annual earnings report is coming out and it doesn't look like it is going to be too good. You have owned this stock for a while and it has proven in the past to be a pretty good stock, so you think there is a possibility that they could be wrong about the value decreasing so you aren't interested in just selling the stock. What could you do?

Simple Illustration

Well let's throw in an example with numbers to help illustrate what you could do. Let's say you had purchased XYZ Company Stock back when they first came on the market at $25 per share. It is currently selling at around $60 a share. That means on this stock you have gained $35 per share owned. Again remember you want to be able to limit your loss if they happen to be correct about the price going down, but you still want to be able to hang on to your stock and possibly gain value if they happen to be wrong.

So you are going to purchase a put option which gives you the right, but not the obligation to sell this stock for $50. If the price of the stock drops down to $40 you may want to exercise your right to sell this stock for $50. Thereby limiting the amount of profits you would lose on this stock. You would be limiting the damage to just $10 per stock owned plus some commissions and the $100 premium you paid for the option. But if the stock does go down even further you are limiting the amount of your loss.

You are using this put just like you would use insurance. You can't predict the future; you don't know that some other guys in the vehicles driving around you aren't going to do anything stupid. So you purchase insurance just in case. It can save you a lot of money and hassle in the future.