You really like the prospects of a new tech company called Wild Data Inc. You buy their shares at $100 a share. Then...you start to get worried. The firm's CEO keeps talking about the healing power of crystals in interviews, and mentioning how they used to be Fredrick William III of Prussia in a former life. You still think the shares will rise in the future, but you want a hedge against the firm's flakey CEO. You decide to buy a protective put.
A put is an option that pays off if the value of an underlying asset goes down. Essentially, it represents a short on the asset.
In your case, you hope you won't need to use it. You hope shares of Wild Data go up. But you buy the put in case they drop.
If the stock goes up (like you think it should), no big deal. You are out the price of the option, but that's it. Small price to pay for piece of mind. If the stock goes down, you're protected. You'll lose money on the lowered share price, but you'll make money from the put. Hopefully enough to offset your losses.
Related or Semi-related Video
Finance: What Is a Call Option?25 Views
finance a la shmoop. what is a call option? option? option, where are you? okay
yeah yeah. not phone options, call options. and a close but no cigar. a call option [man smokes in a tub of cash]
is the right to call or buy a security. the concept is easy the math is hard.
you think Coca Cola's poised for a breakout as they go into the new low
calorie beverage business. their stock is at 50 bucks a share and you can buy a [man stands on a stage as crowd cheers]
call option for $1. well that call option buys you the right
to then buy coke stock at 55 bucks a share anytime you want in the next
hundred and 20 days. so let's say Coke announces its new sugarless drink flavor
zero it's two weeks later and the stock skyrockets to fifty eight dollars a
share. you've already paid the dollar for the option now you have to exercise it. [man lifts weights]
so you buy the stock and you're all in now for fifty five dollars plus one or
fifty six bucks a share and your total value is now fifty eight bucks. well you
could turn around today and sell the bundle that moment, and you'll have
turned your dollar into two dollars of profit really fast. and obviously had the [equation on screen]
stock not skyrocketed so quickly well you would have lost everything. still you
lucked out and now you're sitting on some serious cash, courtesy of your call [two men in a tub of cash]
options. as for Coke flavor zero turned out to be nothing more than canned water.
Up Next
What is a put option? A put option is a type of contract that lets the investor sell shares of a stock at a certain price and within a window of ti...
What are stock options? Stock options are derivative contracts, each representing 100 shares, that give the holder the right to buy (call) or sell...
A derivative of a security is a "something" which derives its value based on the performance of that security... either a put option or a call option.