Investing in the stock market isn't the easiest thing in the world. Make one mistake and you can lose a lifetime's worth of savings in the blink of an eye. One part of the stock market that I find people to have an even more difficult time understanding is the options market.
The fact of the matter is, investing in stock options doesn't have to be all that difficult. Options are a great source of alternative income separate from dividends, and they also allow you the option to hedge your bets for safety.
In this article today I want to talk a little bit about the mechanics of options, specifically of put options. A put option is simply an option that gives you the right to sell a specific security at a set price in the future. The easiest way to explain it in more detail is to simply give you an example so I thought that's what I would do today.
If you think a stock price is going to go down in the future you should buy a put option which gives you the right to sell the stock at a set price in the future. Imagine that the companies share price is currently selling at around $40 per share. You feel that the price is going to drop in the future so you buy a put option at $40.
The premium that you pay for the option may be around a dollar. A month later the price of the shares falls out of the sky down to $20 per share on the open market. Your put option now gives you the right to buy a share of stock for $20 in the open market and sell it at $40.
Your profit is simply the $40 that you sold the share for, minus the $20 that you bought the share for on the open market, minus the one dollar that you bought the put option for originally... so your profit on this trade would be $19 off of a one dollar put option investment. Not bad!
Why would somebody buy a share of stock from you for $40 when the market is selling them for $20? That's the put option! The put option, like all stock options, is nothing more than a contractual obligation and in this case the obligation is to buy the share of stock from you at $40.
So what's the risk involved in this sort of trade? Well it's pretty easy to understand. If you have the right to sell a share of stock at $40 a share and the share price goes up then you miss out on all that upward potential. Let's pretend the share rises to $50 a share. You wouldn't want to sell that share for $40, when you can sell it on the open market for $50 and you wouldn't buy a share at $50 and then turn around and sell it for $40, losing $10 bucks.
Put options are not just a great way to make money, they're even more useful as hedges... as you can see in this example above in that they can hedge your portfolio against losses.
Learning about stock options is incredibly important for all stock market investors at all levels. Even if you're just trading a small account for yourself you should learn as much is you can about both call options and put options, and you'll thank me for it later!