Buying Puts to Protect a Portfolio
One day the stock market is up. The next day it’s down. While ups and downs are part of the stock market, wild swings can give even the most hardened investor a bit of upset. In order to combat those wild swings, there are financial instruments you can put in your portfolio to help keep your portfolio on healthy during the worst swings in the market. These are called put options, or puts.
What are put options? Put options are stock derivatives. When you buy puts, you get the right to sell a specific amount of the underlying stock at a predetermined “strike price.” You buy put options in specific companies. These put options usually have a specific period associated with them from one to three months in length. During that time, you can opt to sell those underlying shares or not. If you do not do it in the specified time line, you just let the put option lapse. The only money you are out is the initial premium you paid for the put option.
So how does buying puts to protect a portfolio really work? There are two scenarios: the underlying stock price goes up or the underlying stock price goes down. Let’s look at each scenario and see how put options work.
If the price of the stock goes down, you will exercise your put options. For example, let’s say you bought a put option for one share of XYZ Co stock with a strike price of $100. The price on XYZ stock goes down to $90 per share. You can exercise your put option and sell the stock at $100. You have not lost the $10 per share in stock price loss on the general market by exercising the put.
What happens if the stock goes up? In this example, you bought another put option for one share of XYZ Co stock with a strike price of $100. The stock price for XYZ goes up to $110. What do you do then? You let the put option lapse. The put option would sell at $100 no matter what the price of the underlying stock was. So, you would not gain anything by exercising the put.
But who is silly enough to buy a stock that is worth less than the strike price? Actually, it’s the seller or underwriter of the put. They are placing the guarantee on the price and they are obligated to cover the price at which they offered the put.