There is an old saying about investing in the stock market: “The market can stay irrational longer than you can stay solvent.” There’s no doubt that this true. Often, we’ll sell a company’s stock because bad news is about to come out, but inexplicably the price of the stock will rise. Likewise, we’ll buy a stock thinking that good news is forthcoming, yet when it arrives the stock price falls. It can be maddening.
However, there is a way to make that madness work somewhat in your favor, and that is with stock options. We’ve already had a brief overview of options and a discussion of selling covered calls in earlier articles. Now I’d like to talk about buying puts.
As explained in my prior articles, a put is the right to sell a stock at a particular price. As with calls, puts can be bought or sold. Normally, this is type of financial instrument is used by the owner of stock to lock in his profits. Basically, purchasing these puts will buy protection for the stock owner in terms of his stock price - hence the term “protective puts”. Let’s see an example of how this would work:
Assume Coca-Cola stock is priced at $63 per share in October. Suppose also, that over the last 60 days, the stock has been extremely volatile, and has traded between the range of $50-$75. You, as the owner of 100 shares of Coca-Cola, have decided to sell your shares within the next two months; you want to hold on to see if the stock will go any higher, but you also don’t want to sell for less than $60 per share. Being familiar with options, you know that you can buy a put, which will guarantee you the ability to sell your shares at a certain price, regardless of what the actual stock is trading for. That being the case, you look at December puts and see that for Coca-Cola a put with a $60 strike price costs $1.50. You buy one put contract at the $60 strike price for a cost of $150. (Strike price and contracts are discussed in the earlier articles.) You can now wait to see if the stock price goes higher, and at the same time rest assured that you will be able to sell your Coca-Cola stock for at least $60 per share, regardless of what the market does.
This, in essence, is how puts work, although there are other aspects to this equation. (For instance, the value of the put purchased will also change, and the purchaser might even be able to sell the put itself for a significant profit.) However, as stated before, options really are a different type of investment vehicle than stocks, and it is advised that you research the concept carefully before indulging in the trading of such.