No one knows with certainty which way the stock market will move, of course, though it is probably safe to say that most people invest in stocks anticipating a profit over time as the equity in their investment rises in value. However, an investor may not always be "bullish" on a stock, and when he is "bearish" on a particular stock he may purchase a "put" option contract, in which he will profit from the stock's price declining.
Options are contracts that give the holder the opportunity to buy or sell shares of an underlying stock at a preset price on or before a preset expiration date. One option contract controls 100 shares of an underlying stock. The cost of buying an option is significantly less than buying 100 shares of the underlying stock. The price you pay to buy an option is the "ask" price, and the price you would get for selling an option is the "bid" price. These familiar terms are the same as buying and selling stock equities. The price you receive when you sell an option, or the price you pay to buy an option, is called the "premium." The "strike price" is the price at which a call option holder can purchase the underlying stock by exercising the option, and the strike price is the price at which a put option holder can sell the underlying stock by exercising the option.
There are two types of options, calls and puts. The buyer of a call option has the opportunity to buy a stock at a preset price (the strike price) any time on or before the contract's expiration date. The buyer of a put option has the right to sell the underlying stock at the strike price anytime on or before the expiration date. Put options are used by investors to profit from the decline of a stock's price. The put option itself increases in value as the underlying stock drops, and the put can be sold to take a profit.
Equity Prices in Relation to Put Values
When you purchase a call option, the value, or price, of the option rises and falls in concert with the price movement of the underlying stock equity. Just the opposite happens when you purchase a put option. The value of a put increases as the price of the underlying stock equity falls. Puts are therefore used by investors who are bearish on a stock in the short term. The drawback to buying options is that time is against you, because all options have an expiration date after which they expire worthless.
Using Puts to Protect Equity Gains
To protect any gain you've made in a stock whose price has risen since you bought shares, you may consider buying a put option. The strategy is to purchase an "in the money" put option -- that is, the current price of the underlying stock equity is below the strike price of the put option. The put option provides a hedge against a drop in the stock's price, since the put increases in value should the stock's price drop. The increase in value of the put will, in part or full, offset any loss in the stock's price.
- Comstock Images/Comstock/Getty Images