This post was originally written on September 17, 2012 at http://www.optiontiger.com/put-options-explained-aapl/
Now that the market has hit 4 year highs, and many high flying stocks are also at similar levels, it may be a good time to protect your profits. Put Options explained in simple terms will give you an idea of why they are the ultimate protector for stocks you own - so let's dig into the nuts and bolts of how Put Options work.
1) Assume you own 100 shares of Apple (NASDAQ:AAPL). AAPL is trading at about $695 today, and let's say you bought it at $600/share. You paid $60K for these shares assuming no margins. You have a paper profit of $95/share.
2) The first thing you have to decide is how long you want the protection for. If you feel AAPL may come down in the next 3 months, then you need protection for 3 months. On the other hand you may want protection for a year. The longer you need protection for, the more your Put Option is going to cost. Makes sense. You pick your protection timeframe shown in Figure I (The number in brackets is the number of days until this Put Option expires). Lets pick 3 months for our example.
3) Just like you choose other insurance plans, you decide what kind of insurance you want. You can get the Ferrari plan, the Cadillac plan or the Kia plan. Obviously, the Ferrari plan costs more than the Cadillac which costs more than the Kia plan. (Figure II and III)
4) The Ferrari plan can protect your AAPL stock below $700. But you pay more at $45/share. The Cadillac plan costs less at $26/share but protects your stock below 660. And the Kia plan is the least costing $16/share, but protects your stock below $630. (Figure IV).
5) Put Options increase in value when the stock goes down, and this is why Put Options are the ultimate protector of your stock. Its like buying insurance - but all insurance costs money. Think of it this way - if you own a car worth 60K, you don't think twice about protecting it with insurance that may cost $1000 - to $1500 per year. Its no different for a stock, if you have profits, you should protect it.
6) Figure V shows the Ferrari plan (100 shares of AAPL and 1 Option contract which is equivalent to 100 shares). Below an AAPL price of $700, your losses are protected, as shown by the horizontal green line which is flat. No more losses. But on the upside, if AAPL continues to go up, your profits keep increasing. Talk about having the cake and eating it too.
7) Figure VI is the Cadillac plan. Protection only kicks in at a price of $660 or below. But you paid much less for this Put Option. And Figure VII is the Kia plan, which protects you at a price level of $630.
8) All 3 Options provide protection for your stock. Your coverage differs but your cost also differs. You make the choices - how long and at what point do you want the protection and how much you're willing to pay for it. Your reward will also depend upon your choice. The Ferrari Put option will make a profit much before and much more than the Cadillac Option, which will make much more than the Kia Option.
9) One important point to bear in mind is that all Options expire. The 700 strike price Option will be worth 0 in 95 days if AAPL price is above 700 on the day of expiry. On the other hand, if AAPL price is 650, then the 700 strike Put Option will have a value of $50/share (the difference between 700 and 650. This is called the intrinsic value of the Option). Similarly, the Cadillac Option at 660 will be worthless if AAPL price is above 660 on the day of expiry. And the Kia Option will be worthless if AAPL price is above 630 on the day of expiry. This is just like buying car insurance for a year, but you did not have an accident or claim of any sort, so your Option (insurance policy) expired worthless. You gotta buy new protection now. Same goes for your AAPL stock.
10) Let's say AAPL crashed to 400. Your stock would lose $200/share because you bought it at $600. The Ferrari Option at a strike price of 700 that you bought for $45 would be worth $300, so your net gain would be $55 (300 - 200 - 45). The Cadillac Put Option would be worth $260, so your net gain would be $34 (260 - 200 -26). The Kia Put Option would be worth $14 (230 - 200 - 16). You make a profit in all 3 cases even though AAPL crashed to $400.
Put Options provide the ultimate protection on the downside, while preserving your ability to make profits on the upside. Check out Modules II and III for complete courseware, and live trading examples.
As if structural factors were not enough, the economy has to battle this additional headwind in the coming years.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.