We have already learned through the previous posts that put option is the contract that gives a buyer tight but not obligation to sell a stock at an agreed price (strike price) on or before a specified date (expiration).
So, far we have seen what call options are and what would happen to a call option depending on the stock price moves during its life. Let’s see the fate of a put option in action in this post.
Put option is purchased in order to profit from a down side move in a stock price. You make money when the stock price goes down when you own a put option on the stock. Another important use of put options are they are popularly used as protective instruments or insurance on a stock already owned. For example let’s say you own 500 shares of Intel Corp. (INTC) with a purchase price of $18.50. You could buy 5 contracts of put options for 4-6 into the future by paying about $100 per contract or $500 total price for $17.50 strike which gives a right to sell INTC at $17.50 no matter how low the stock price goes to before the expiration while still enjoying the gains if the stock continues to climb.
Let us look into a hypothetical example of what would happen to a put option purchase (buy to open) before we sell it (sell to close). This time around let us imagine a trade initiated on Research in Motion Inc. (RIMM) maker of the popular smart phone Black Berry, trades on NASDAQ, and closed at $40.10 as of Sept. 14th. This stock has strike prices at $2.5 intervals near the closing price. The picture below shows the details of the put options table for Oct. expiration on RIMM stock again October was chosen for the obvious reason of following the paper trade.
Please refer to the previous post for an explanation of what each column represents.
Note that there are put options above the stock price in the picture. They are called out-of-the money options and the options $47.50 strike and above are called in-the-money options.
Our imaginary trade:
As you can see from the picture above that the October $45 puts have a premium (cost) of $2.79 indicating the expiration is the third Friday of October and the strike price is $45. The total price of the contract is $2.79 x 100 = $279 without commissions.
When you buy the above put option you have an option to sell 100 shares of RIMM at $45 on or before October 15th 2010. The stock price must fall below $42.21 to break even and further below to make money on this trade.
For the purpose of this example, let’s say the stock price moved down to $41.50 by Sept. 27th. The option contract has increased as the stock price moved down and is now worth only $4.25 x 100 = $425. That means now you have a profit of ($425 - $279) = $146 on your initial investment of $279. If you decide to ride the trend down as there is more time left before the option expires. Now, by Oct. 8th the stock price gained and moved to $43. The options contract has lost some of the premium though it is still in the money by $2 so now worth only $2.75 x 100 = $275, and you are barely close to breakeven ($2.79 - $2.75) x 100 = -$4.
By the expiration date, the price drops again to $38.50. Because this is less than our $45 strike price our trade is in the money and we have a right to either exercise the option and sell 100 shares in the open market or sell-to-close the option which would be worth ($45-$38.50) x 100 = $750 and book the profits of $750-$279 = $471 after subtracting your initial investment. Note that there is no premium value left as it is the expiration day.
To summarize, here is what happened to our option investment:
RIMM Oct. 45 put | Sept. 15th | Sept. 27th | Oct. 8th | Oct. 15th Exp. |
Stock price | $45.10 | $41.50 | $43 | $38.50 |
Option Price | $2.79 | $4.25 | $2.75 | $7.50 |
Option value | $279.00 | $425.00 | $275.00 | $750.00 |
Profit / Loss | $0 | $146 | -$4.00 | $471.00 |
Caution: Please do not initiate any trades based on our imaginary examples as this could result in total (100%) and be advised that none of the content in the post is any advice or promotion of any sort and should be completely treated as educational material only.
That’s about the life of a put option. Do you know what happened to the seller of the put option in that example? Think about it.
More options related stuff in the next post. Don’t forget to leave your comments and suggestions and come back again for an exciting learning experience.
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