What is a put option?

A couple of weeks ago, I wrote about a strategy for investing with no losses. Part of the strategy requires buying a put option. When it came to the part of the article where I might have explained what a put option is, I said:

“If you’re not familiar with put options, I encourage you to invest some time in understanding them. I promise that investment of time will be a no loss investment as well.”

That was mainly an attempt at keeping the article short, and an attempt at leveraging the rest of the Internet where other people have already explained put options. However, I’ve had many people tell me that options are just too complicated for them.

What that means to me is that the explanations these people have received so far are just not good enough. So I’ll see if I can do any better. (And if I don’t, let me know. If you do not understand the explanation, I’m just not explaining it well enough because options are not that difficult.)

I’m going to explain put options from the perspective of the No Loss Strategy. [1]

Purpose

Sometimes it’s easier to describe something by what its purpose is, rather than by describing it directly. If I told you something has 4 wheels, a steering wheel, and a gas tank, you might guess that I was describing a car. But if I instead told you its purpose is to cut grass, you’d be pretty sure I was talking about a lawnmower.

So the purpose of buying a put option is to protect your investment. If the price of your stock on the market goes down but you own a put option on the stock, the put option is a guarantee that there is someone that will buy that stock from you for a higher price. This means that even if the stock goes down, you don’t lose money. Keep that purpose in mind as we go through the definition.

Definition

Investopedia’s definition of a put option is:

“An option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time.”

This definition can be found in most textbooks, which doesn’t say anything about its helpfulness. I understand it now, but if I didn’t already know what a put option was, I don’t think I would. So let’s break it down and see if we can make some sense out of it.

“…option contract…”

So when you buy an option, you are making a contract with someone else. A contract is just an agreement. So you’re making an agreement with someone else.

This is not that unusual. When you buy something you are making an agreement that you will give the seller the money, and the seller will give you the thing. Another contract might be when you pay for insurance and the insurance company agrees to cover you for the next month. Or when you buy an extended warranty and the warranty company agrees to repair or replace your item for the next year.

“…the right, but not the obligation…”

This is a convoluted way of saying that the person who pays the money gets to decide if they want to use the service they paid for. If you bought a ticket to a baseball game, but then weren’t feeling well on the night of the game, it’s your choice if you go or don’t go. The ticket seller can’t force you to go. So when you buy an option, the person you buy it from is waiting for you to decide if you want to use what you bought or not.

If you do decide to use it, that’s called exercising the option, exactly the same idea as exercising a right, like exercising your 1st Amendment rights.

“…to sell…”

So buying a put option gives you the choice of whether or not to sell your stock. But you always have that choice. The difference here is that the person that sold the put option in the first place is required to buy your stock when you want to sell.

“…to sell a specified amount of an underlying security…”

Underlying security just means a stock. So it means, “to sell a specified amount of stock”. The specified amount is how many contracts you bought.

Options come in contracts, like eggs come in dozens. A contract is a fancy way of saying a “block of 100 shares”. So if you buy one put option contract, then you have bought a warranty on 100 shares of stock. If you buy two contracts, then it’s 200 shares of stock. [2]

“…to sell…at a specified price…”

So the other side is agreeing to buy your stock for a specific price, which you decide at the time that you buy the put option. This specified price is called the strike price.

“…to sell…within a specified time”

So the other side is agreeing to buy your stock for a specific amount of time, which again, you decide at the time that you buy the put option. This specified time is the time until the expiration date. The expiration date is the same day of each month for all options.

Example

Now let’s put that all together in an example and see if it makes sense.

Let’s say you buy 200 shares of Johnson and Johnson (JNJ) for $71.33 per share. But you realize that there is always a possibility that a stock will fall in price. So you want to protect against your investment falling in value. So you buy a put option.

You decide to buy 2 contracts, since you want to protect all 200 shares. If you bought only 1 contract, then you’d only be protecting 100 shares of your stock and the other 100 shares have the potential to fall all the way to zero.

You decide that you want to protect the stock for at least the rest of the year. So you go take a look at the options for sale. There are contracts for sale on JNJ that expire in September 2008, October 2008, January 2009, and January 2010. The best fit for the time frame you want is the January 2009 options.

Now you need to pick a strike price. The price that you want to be able to sell the stock at no matter what it’s worth on the market. The amount of insurance you want. The available strike prices for sale are $40, $50, $55, $60, $65, $70, $75, $80, $85, $90, $95, and $100.

If you pick a strike price of $40, you’ll only be protecting $40 of the $71.33. If you pick a strike price of $100, you’ll be paying for way more protection than you need. So ideally for this strategy you want to pick something closer to the price you paid, but still high enough to protect your entire investment.

The strike price of $75 costs $5.30. So if the stock drops in price, and you exercised the option, you get paid the $75 for the stock, and paid out $5.30 for the option and $71.33 for the stock originally. You would have a net loss of ($75 – $5.30 – $71.33 =) -$1.63 per share. That’s still not a complete protection from losses.

So let’s move up one strike price to $80. The cost of this option is $9.30. So if you own this put option and the stock drops in price, then you would have a net loss of ($80 – $9.30 – $71.33 =) -$0.63 per share.

But we’re forgetting the two dividends that JNJ will likely pay out between now and January 2008. One is expect on 8/22/2008 and if history repeats, then the other is expected around 11/24/2008. And the dividend amounts will probably be about $0.46 per share. So if you add the two dividends to the expected net loss, you get a net gain of (-$0.63 + $0.46 + $0.46 =) $0.29 per share.

So the worst-case scenario is you make a gain of $0.29 per share.

Summing up

So that’s it.

– You choose the stock you want to protect.
– You choose how many shares you want to protect.
– You choose the expiration date.
– And you choose the strike price.

If you’re interested in the No Loss Strategy or you have any questions about it, feel free to send me an email at contact@dividendium.com.

[1] There are other ways to use put options for investing or speculation, and I may come back and explain those in the future if it seems like there’s some interest.

[2] There are some option contracts that are “non-standard” and are not 100 shares. You should check with your broker if you aren’t sure if the contract you want to buy is standard.

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