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Buying Puts

Suppose you look at XYZ stock and think to yourself, “Now there’s a train wreck waiting to happen.” You can see that the price is going down soon -- but how can you make a profit when a stock loses value?

A put option allows you to do just that. It’s basically buying a call option in reverse. Let’s say that XYZ stock is trading for $10 a share in June. You just know in your bones that it’s going to tank by August. You buy the XYZ August $12.50 put option for $2 a contract. Your $200 now buys you the right to sell, or put, 100 shares of XYZ, at $12.50 a share, anytime before the third Friday in August. You do this because you fully expect it to drop like a stone – possibly all the way down to zero.

Let’s say you were right on the money. XYZ is a dog and falls to $5 a share. You can exercise the put and sell 100 shares of XYZ at $12.50 – then buy 100 shares of XYZ at the current price of $5 for a profit of $7.50 per share, minus the $200 you paid for the option, and commissions. Unlike a call option, in which you first buy and then sell, those who exercise put options sell the stock first -- and then buy the stock back at a lower price to complete the transaction. If you don’t want to hassle with buying and selling stock, you may simply choose to sell the put options, which rose in value when the price of the underlying stock fell.

But here’s the corresponding risk: say you buy one XYZ August $12.50 put contract at $2. A week later XYZ shoots up to $15 a share. You’re now in the red, and your losses only mount as XYZ continues to climb. You must then sell your put option at a loss or let the contract expire worthless.

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Updated on 1/11/2017.

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