All investments in the stock market involve some level of risk. You may be able to reduce, or hedge, your risk by employing certain investment strategies, such as buying stock and buying protective put options on that stock to guard against sudden precipitous drops in the stock's price. Some hedge strategies involve more exotic practices that can include a combination of buying and selling put options for the same underlying security.
There are two primary types of stock options, including call options and put options. A call option gives the holder the right, but not the obligation, to purchase a specific number of shares of stock at a specific price for a set period of time. A put option gives the holder the right, but not the obligation, to sell a specific number of shares of stock at a specific price for a set period of time. If you sell a put option, you receive a premium in exchange for agreeing to purchase a specific number of shares of stock for as specific price upon demand for a set period of time.
Buying Put Options
Investors typically buy stock with the expectation that the price of the stock will increase, but there is always the possibility that the stock price will decrease, resulting in a loss. A common method of hedging your stock investment is to buy a put option with a strike price that represents the amount you are willing to lose on your investment. If the price of the stock drops below the strike price, you can exercise your put option to sell your stock for the specified price, and thereby reduce your downside risk to a known level.
Selling Put Options
You can earn a premium by selling a put option, provided you are willing and able to purchase the required amount of stock if the put option is exercised. If you wish to acquire a position in a stock, but believe the price of the stock will decrease in the near future you may wish to sell a put option with a strike price that is at or near the price you believe is appropriate for the stock. If the put option is exercised, you will obtain the stock for the price you believe is appropriate and the price will additionally be offset by the amount of the premium you received for selling the put option. Selling put options, apart from other transactions, is not usually considered to be a hedge strategy.
Bear Put Spread
A put is said to be in-the-money when the underlying stock is trading below the strike price, so the price of the put tends to move in tandem with the price of the stock. A put is said to be out-of-the-money when the underlying stock is trading above the strike price. You can sell a put option in tandem with purchasing a put option in a hedge strategy, commonly referred to as a bear-put spread. A bear-put spread involves selling an out-of-the-money put option, and simultaneously buying an in-the-money put option for the same underlying security with the same expiration date. Holding the in-the-money put provides you with a bearish position in the security. Selling the out-of-the-money put helps offset the cost of establishing that bearish position.
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