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.
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Finance: What are stock options in 90 se...0 Views
Finance allah shmoop what are stock options in ninety seconds
or less Here's a stock ibm not the tech company
This one makes an anti constipation drug It's trading at
one hundred eighty bucks a share Okay so here's an
option of buy a share of ibm anytime in roughly
the next three months For one hundred ninety dollars a
share it's called a call option If you really believe
the ibm will go to say two hundred dollars a
share in the next three months well you'd be what's
called ten dollars in the money then or then have
a stock option or call option with a strike price
of one hundred ninety dollars which would then have intrinsic
value of ten bucks a share On the other end
of the buy sell desk is the gal willing to
sell you that call option for three bucks Three bucks
a premium So gut check time Would you pay three
dollars for the right to buy a share if ibm
for ten dollars higher than where the stock's trading now
today Meaning that to break even in the next three
months the stock has to trade all the way up
from one hundred eighty dollars a share to one hundred
ninety three dollars a share jobs for you to get
your money back but it goes to two hundred two
share Well if you sell that option you'll have invested
three bucks a share for a net return of seven
bucks in just three months or less And yes we're
ignoring commissions and taxes here because well in problems like
this or just a in the book but three dollars
into seven only three months Yeah that's a great score
You'd have more than doubled your money And on an
annualized return basis that's over a nine hundred percent dish
return really good score but with a much more likely
case that you spend three bucks to buy the option
and it expires totally worthless And then you've lost your
entire investment in that option So that's a call option
It's evil twin is a put option So whereas a
call options the rightto by a security to set price
by a certain set date a put option is the
right to sell that option We'd go into more detail
here but we're promised ninety seconds
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 is a call option? A call option is a type of contract that lets the investor buy shares of a stock at a certain price and within a window of t...
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.