Put and call options examples
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. A call is a contract that gives the owner the right, but not the obligation, to buy shares of a stock at a fixed price, called the strike price, on or before the options expiration date.
If the value of the stock goes down, the price of the option goes down, and you could hold it or sell it at a loss. The price that you pay for a call option depends on many factors two of which include: See the following videos: If you own a stock, you may buy a put as a form of insurance. If the stock falls in price, the put rises in price and helps offset the paper decline in the underlying stock. If you don't own the stock but think it will go down in price, you buy the put to profit from the decline in price of the stock.
If the stock price declines, the value of the put rises and you would sell the put for a profit. If the stock increases in price you may sell the put for a loss. A put option is a contract that gives you the right, but not the obligation, to sell a stock at a preset price.
The price that you pay for a put option depends the duration of the contract the longer the duration, the more you pay and how far the current price of the stock is from the strike price of the contract. Put buying is different from selling short. With a put option your only liability is the price you paid for the put. With a short sale, you have an unlimited downside liability if the stock goes up. Also, the proceeds from selling short are in a margin account so you have to pay interest and meet margin requirements.
Buying puts is a more conservative way of betting on a stock declining in price. Selling a Call For every buyer of a call there must be a seller, who assumes that the stock price will remain flat or go down. The seller collects the purchase price of the option but has the obligation to sell shares of the stock if the buyer decides to exercise the option. If the seller gets called - he must sell the stock.
If the stock continues to appreciate in price after the stock is sold, the seller looses the future price gain. In most cases you must own shares of the stock for each contract you sell - this is called a covered call. Therefore, if your stock gets called away, you have the shares in your account.
You can sell covered calls to generate a stream of income. If the stock price does not rise enough during the period of the contract, you won't get called and won't have to sell the stock so you keep the money you received when you sold the call. If your broker lets you, you may sell "uncovered "or "naked" calls in a margin account. This practice lets you sell calls when you don't own the stock. If you get called, you must buy the stock at its current market value to cover the call even when the market price is higher than the strike price of the option.
Like any margin account transaction, you must execute the transaction immediately. The seller of a put collects the purchase price of the option from the buyer of the put. The seller has the obligation to buy shares at the strike price regardless of the market value of the underlying stock. So if the put buyer decides to exercise the put contract, the seller of the put has to buy the shares at the strike price no matter the current market value of the stock. When you sell a put, you want the price of the stock to go up so you don't get the stock put to you - buy the stock for more than it's worth.
Selling a put places the money you receive in a margin account so you pay interest on the proceeds until the put contract is closed. If you don't have the financial resources to cover the obligation of buying the stock from the buyer of the put, you sold "naked puts". It tells about a trader who sold naked puts and experienced financial ruin. It was an unhedged bet, or what was called on Wall Street a "naked put" On October 27, , the market plummeted seven per cent, and Niederhoffer had to produce huge amounts of cash to back up all the options he'd sold at pre-crash strike prices.
He ran through a hundred and thirty million dollars - his cash reserves, his savings, his other stocks-and when his broker came and asked for still more he didn't have it. In a day, one of the most successful hedge funds in America was wiped out. Niederhoffer was forced to shut down his firm. He had to mortgage his house.