A put option is a contract giving the right, but not the obligation, to sell or short a designated amount of the underlying security for a specific price within a set time frame. As a hedge, the put option protects against market downturns, usually for long positions.
According to Investopedia, "By purchasing a put option, an investor is transferring the downside risk to the seller. In general, the more downside risk the purchaser of the hedge seeks to transfer to the seller, the more expensive the hedge will be."
Buying an option is a relatively simple process and, therefore, appropriate for most investors.
Put options function a bit like flood insurance. Short of a disaster, the protection becomes a liability.
Moderate to High
Put options often trade for a premium due to the unlimited risk the seller assumes.
An investor determines that XYZ stock is a good buy at $50 per share. They believe the price will go up, but to protect the probability of moving downward, decide to hedge with a put option.
For the fee of $25, this put option guarantees the right to sell the stock at $45 within a one-year time frame. If the price of the stock purchased has increased in six months, then the option is not exercised, losing the $25.
If the stock price decreases to $40, the option is exercised, selling the stock for $45, reducing the loss to $5 per share. Without this option, this investor would have lost $10 per share.
© 2020 Todd Moses
The strategies discussed are for illustrative and educational purposes and are not a recommendation, offer, or solicitation to buy or sell any currency or to adopt any investment strategy. There is no guarantee that any strategies discussed will be useful. Todd Moses is not a licensed securities dealer, broker, or US investment adviser or investment bank.