A put option is the right to sell a stock at a certain price known as the strike price.Â You are paying a price for the put option which in return gives you the right to sell your stock to the seller of the put option.
Put options are sometimes referred to as insurance on your stock.Â What that means is that if you own stock in XYZ Company and the price tanks you are â€œprotectedâ€ because you have the right to sell your stock to the seller of the put option at a much higher price than what it is trading at after it goes down.
How Purchasing a Put Option Works
Letâ€™s say you own 100 shares of XYZ Company and the stock has increased a lot.Â You still want to own it but are afraid that it has went up so much and you want to lock in some of your gains.Â If the stock is trading at $20 in June you might purchase a put option with a strike price of $20 for 50 cents.
You are paying 50 cents for the right to sell your stock to the seller of the put option should the stock fall.Â If at the expiration date of your put option the stock was cut in half to $10 you are protected from this fall because you own a put option that gives you the right to sell your stock for $20 even though it is trading at $10.
On the other hand if the stock is trading at $30 at expiration all you are out is the cost of the put option.Â You do not have to sell your stock for $20 because it is your right to choose not to.Â Basically you paid 50 cents to protect yourself in case something bad happened to your stock.
Reasons for Purchasing a Put Option
This strategy is often times employed by a lot of big investment companies who are afraid the market could go down and they want to protect their gains.
The main reason for the average investor to sell a put option would be if they had a large gain in the stock but donâ€™t want to sell it because of tax reasons.Â They could purchase a put option that would protect them if the stock went down before they were ready to sell their stock.