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Buying a PUT option on a share gives the buyer the option (but not the obligation) to sell a set share at a set price until a set date.

Puts can be used as insurance against a fall in the price of the shares you own. If you bought some shares of a stock and its price went up when you bought a put option on the stock at the new price, you have in effect blocked the increase in the share price.

Options for laymen

I think the home buying analogy is one of the best ways to explain how an option works, so I’ll use that basic premise here.

Cash values ​​are just for simplicity and this will obviously work for different options and stock prices.

Case Study: Buying a Put Option on a Home

We have a house that is currently selling for $ 100,000.

We believe that house prices may go down but we do not want to sell the house this month, we approach a buyer with a Contract (proposal).

Our contract states that we will give the buyer $ 1,000 for the option (the right but not the obligation) to sell the home at the list price of $ 100,000.

The contract is valid for 30 days and if we do not sell the house within that period, the buyer will keep the $ 1000 and there will be no further commitment on our part.

In fact, we have purchased the equivalent of a one month put option on the property.

The contract is valid for 30 days and if we do not sell the house within that period, the buyer will keep the $ 1000 and there will be no further commitment on our part.

In fact, we have purchased the equivalent of a one month put option on the property.

o If the housing market explodes (in the next 30 days) and the house is now valued at $ 110,000, we let our option expire worthless and can sell the house for $ 110,000.

$ 110,000 (present value) – $ 1000 (option price) – $ 100,000 (starting price) = $ 9000 (our earnings).

o If the housing market collapses (within the next 30 days) and the house is now valued at $ 90,000, we can exercise our option and sell the house for $ 100,000.

$ 100,000 (sale price) – $ 1000 (option price) – $ 90,000 (current value) = $ 9000 (our locked value).

Contract sizes

On the Australian Stock Exchange, a standard sales contract generally covers a thousand underlying shares (some contracts are odd-numbered, so keep in mind the number of underlying shares that the option contract covers).

On the New York Stock Exchange, a standard sales contract generally covers one hundred underlying shares.