By Darrell Martin
As explained in the previous article, Simplifying Options: Calls, an option is a contract between two people, giving one the right, but not the obligation to buy (call) or sell (put) an asset at an agreed upon price during a specific time. Where call options give the option to buy at a certain price, put options give the option to sell at a certain price. This article will delve into explaining puts.
A put option can be likened to buying insurance. Let’s look at an example to make it easier to understand.
Put Option Scenario
Carol has a house worth $100,000 and buys homeowners or renters insurance at $1,000 to reimburse her $100,000 (strike price). This is similar to a put option since she paid $1,000 for the full coverage policy; it is considered At The Money (ATM).
If the house does burn down, Carol is out the $1,000 she paid for the fire insurance, but she gets back $100,000. She only lost the premium instead of the house (hypothetically).
David also has a house worth $100,000 and buys insurance at $200 to reimburse him $90,000 (strike price) if the house burns down. This is like having a $10,000 deductible or loss in value of the home, which is not returned on the insurance policy. If the house burns down, David will get $90,000 but would be out $10,000 of deductible. True, he only paid $200 in premium, which is cheaper since the put option is considered Out of The Money (OTM). This gives David a deductible amount for which he will not be reimbursed. Since David paid less, he got less.
Relating the Example to Trading
This is the same as when trading spread options. There are very cheap ones available. However, they do not move as far as fast. Homeowners insurance allows the policyholder to be reimbursed if the home burns down. A put option can be viewed as insurance on a stock going down, which can be “reimbursed” for the stock “burning” down.
Buying put options on stock, futures or forex that are not owned by the trader, enables hedging so if the instrument does move down, you can make money. Learn how to use Nadex spreads as a hedge against risk for futures and forex trades in an article titled Using Nadex Spreads as the Ultimate Hedge Strategy.
This basic example relating puts to insurance can help simplify understanding put options. It is an agreement made between two parties giving one the right, but not the obligation to sell an asset at an agreed upon amount.
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