Puts As Insurance

Another important use for put options is insurance on stocks that you own. If you own a stock and you have a forecast that the stock may fall, you can purchase a put option to help as protection against the decline. If the stock does fall, then the option goes up in value and offsets the declining value of your stock.

This strategy is similar to someone that purchases fire insurance on his or her house. If the house burns down, then they get money to build another house. If it doesn’t burn down, then they’ve paid for insurance that they didn’t use. If you buy a put option on a stock and it doesn’t fall, then you’ve essentially paid for insurance that you don’t use.

Typically you would only use puts on a fundamentally sound stock that is still showing overall technical strength, but may have a short-term pull back. You could also buy some puts on a stock that has an impending announcement that is extremely uncertain, and you don’t want to be left without protection, but you’d like to keep the stock in case the news is good. A company that is awaiting FDA approval on a new drug would be a good example of such a situation.

You are using put options as a form of insurance against downturns in the price of a stock, without losing the upside potential of stock ownership. Let’s say that you own 100 shares of XYZ, purchased at $60 a share, a $6000 investment. XYZ has increased to $81 you have an unrealized gain of $2100; but you now have short-term concerns such as an earnings announcement or bearish sentiment in the markets.

You don’t want to sell your stock and take the short-term capital gains and you think in the long term the stock will continue to rise. By purchasing 1 XYZ JUN 80 PUT for $4, you acquire the right to sell 100 shares of XYZ, the same number of shares that you own, for $80 anytime before expiration while keeping your stock. Here is the formula for how much protection you have bought.

Strike price of put $80; Stock purchase price $60; Premium $4; Protected profit $16 per share. You have protected $1600 of your $2100 gain!

If the stock moves up you will lose the $400 it cost you to buy the insurance, but you will have the gain in the stock to off-set the cost of the, in this case, insurance premium.

It the stock moves down, let’s say to $50 for our example, you would still be able to sell your stock for 80 per share minus the 400 it cost for the put.