Put Options are like buying one of those insurance policies that the old man in the cheap suite tried to sell your grandpappy in case his crop of corn turned out to be crap that year. At first glance it seems shady and expensive, but in reality when compared to potential losses it makes perfect sense.
OPTIONS DEFINE RISK
Keeping with grandpappy’s farm analogy: Your grandpa had corn. Lot’s of corn. All he cared about was corn and making sure that come harvest time that corn was still there and still worth enough money to pay for his family’s future corn needs. He needed to make sure he kept the value of said corn regardless of what might happen to the corn or the world around him. This was imperative to his family’s future (sound familiar?). The insurance salesman in the cheap suite offers to pay for his corn at a predetermined price for a predetermined amount of time. The insurance salesman is the seller of the put option and your grandpappy is the buyer of the put option. It’s that simple.
WTF IS THE CORN AGAIN?
In this analogy the corn is the underlying asset (stock). The predetermined price the insurance salesman will pay grandpappy for the corn is the strike (stock price). The predetermined amount of time is the expiration date (maturity) of the option contract.
Option Facts: Put Options are really just insurance policies! Options are also legally binding contracts between two parties and are not associated with the company itself. In other words, the underlying company can go bankrupt and the buyer of the put still has the right to sell his shares to the seller of the put and the seller still has the obligation to buy said shares even if they’re worthless.
REAL WORLD EXAMPLE
Buying insurance is often expensive, but let’s think about it: If you own 1000 shares of NDVA and you’re up $30,000.00 you are might be nervous and worried about losing all of your gains. To help you sleep you could buy a put option to “protect” a certain amount of those gains for a certain amount of time – like through an earnings announcement on Feb 8th.
You would first need to determine your objective and timeline. If you’re looking for 1st Qtr protection then you could buy a March Put Option to cover the entire 1000 share position at the $225.00 per share strike price (nearly $3.00 per share more than where the underlying stock closed Friday) for $15,000.00. This would cover you for the entire 1st Quarter or three (3) months of 2018.
Now, again, this seems really expensive, but keep in mind that’s $3.00 per share higher than where it closed Friday so that makes your actual realized cost only $12,000.00 for the policy because the seller is going to pay you $225.00 per share regardless.
If I’m holding $222,300.00 worth of stock on Friday with an unrealized gain of $30,000.00 YTD and you came to me and said, “I will guarantee that you will not lose more than $12,000.00 (the cost of the insurance minus the $3.00 extra per share) total, regardless of what happens, I would take it. Especially if I was the least bit worried about earnings…
OPTIONS ARE FUN!
That’s all there is to it. In this example grandpappy was the buyer of the Put Option and this should be interpreted as a negative sentiment towards the future of his corn or maybe he’s just scared to death of losing his ass again like last year when his neighbor Jesse set the corn field on fire during the 4th of July town gathering. Ol’ gramps decided at that moment he would never watch his family fortune go up in flames again without having some protection. You, the savvy investor reader person may be thinking this is dumb and expensive, but never judge a man until you’ve walked in his shoes.
Regardless, the term “put” comes from the fact grandpappy, as the buyer, has the right to “put up for sale” his corn. No matter what happens to his corn (even if Jesse sets it on fire) he will be paid the predetermined price (strike).
Options may seem risky or scary or complicated, but they are not. They should be viewed as tools and can be used strategically. In this example, a put option is used to protect your portfolio gains.
Corn was probably a bad example because it’s a commodity and likely to be worthless to the insurance company upon claim (especially if on fire). Stocks are different in this respect and typically have intrinsic value remaining when or if “put” to the insurance policy holder (seller of the put option).
In other words, NVDA might be down at the time of expiration and the insurance company (seller of the put option) might be put the shares at that time, but it doesn’t mean it won’t come right back up. The corn on the other hand, once burned, would be forever destroyed.
Also, NVDA was probably a bad example as well because option premiums are elevated for NVDA currently and it’s expensive to protect.
For those that are wondering and thinking ahead: if you were the insurance man in this analogy (the seller of the put option) and you were paid $15,000.00 from grandpa (the buyer of the put option) and NVDA was below the strike of $225.00 at expiration and you were put the shares your cost basis for the actual shares of stock would be $225.00 minus what you were paid from grandpa (the buyer) or $15.00 per share . This means your actual realized cost basis would be $210.00 per share. However, your portfolio would show your cost basis as $225.00 per share because that’s the price you were put the shares. Ok, enough explaining…tweet me @bullorbust if you have questions!