In last week’s article, we looked at call options and how you can buy them in anticipation of a stock price going up. If you didn’t get a chance to read the article, then please click here.
To give you a quick recap, a call option gives the buyer the right to buy shares in a company for a specified price (called the exercise or strike price) at any time until the option expires.
The person who sells this call option to them, the option ‘writer’, takes on an obligation. They must hand over the shares at the strike price if the buyer exercises their option. For taking on this obligation, the option writer receives a premium.
Let’s now take a look at put options. You buy a put option when you think the share price might be headed for a fall.
A put option gives the buyer the right to sell shares in a company for a specified price (also called the exercise or strike price) at any time until the option expires. As with a call option, the put option writer receives a premium for taking on this obligation.
There are two main reasons for buying a put option. First, you can buy a put to protect your existing shares from a potential fall — like a form of insurance.
Second, you can buy a put option to speculate. The value of a put option increases as the share price falls. Even if you don’t own the underlying shares, you can buy a put option with the hope of selling it later for a profit before it expires.
For the purposes of this article, we’ll concentrate on using put options as a way to protect your shares.
Please note that this example is shown for illustrative purposes and is not a recommendation.
You want to hold your Westpac shares for the long term, but you’re worried about the recent level of volatility. What happens if the share price takes a tumble?
If you sell your shares — instead of falling, the share price might do the opposite. They could go up in value. Plus you want to collect any dividends Westpac pays you along the way.
Buying a put option is one way of covering both angles. It allows you to participate in any upside, while also protecting you from any potential downside. Let me explain.
As a put option buyer, remember you are buying the right to sell your shares at the strike price, at any time up until the option expires. If you exercise that right, the option seller must take delivery of the shares at that strike price.
However, if the share price goes up or even trades sideways, then you won’t need to exercise that right. You just keep your shares and let the option expire without exercising it.
It’s easiest to think about it the same way you do about your house insurance. You pay a premium to your insurer to protect you if something happens to your house. Like a fire or a wild storm. If nothing happens to your house, then you have no need to make a claim.
And so it is when you buy a put option on a share. It allows you to sell your shares if they fall below a predetermined price. That is, the strike price. If they don’t fall below that price, then you won’t need to exercise your option. Or in insurance speak, you won’t need to make a claim.
But back to the Westpac example. Take a look at the following table — it shows a range of put options available for Westpac.
All options have expiries — just like your home insurance. An option has no value once it expires. These Westpac put options listed above all expire on Thursday 28 January 2016.
One of the great things about options is their flexibility. You can choose from a range of different strike prices and expiry dates.
I’ve circled a Westpac put option above with a strike price of $29.30. If I buy that put option, that gives me the right to sell my Westpac shares to the option seller at $29.30 at any time until the option expires in January.
The next column is the option code. Each option has its own unique six digit code designated by the ASX. This is the code you quote when you place your trade.
The next columns are the bid and offer prices. That is, how much the option buyer is willing to pay for that option. And, how much the option seller wants to receive for selling that option. In the option I’ve circled, that’s a 52 cent bid and a 61 cent offer.
Let’s say you put your bid price in at 55 cents to buy that option and the trade goes through. That is, the option seller agrees to sell you that option at 55 cents. Let’s work out how much your option is going to cost and what happens from here.
Each option contract is typically for 100 shares. As we have 300 Westpac shares, we would need to buy three put option contracts. At 55 cents, that would cost us $165 plus brokerage. That’s calculated by three contracts times 100 shares per contract times 55 cents per share (called the premium).
That buys us insurance on our Westpac shares until the option expires on 28 January. Let’s look at two different scenarios to see what can happen from here.
First, if the share price is trading above $29.30 when the option expires, there is no point in exercising the option. That’s because you could sell the shares for a higher amount than the strike price in the market.
Second, if the share price is trading below $29.30 when the option expires, then you’d look to exercise your option. In this case, it allows you to sell your shares for a higher amount than what you’d receive in the market.
In this second scenario, the option is referred to as in-the-money at expiry. That is, the share price is below the strike price of the put option when it expires. One thing to keep in mind is that your broker will usually exercise any in-the-money options at expiry, so you need to advise them if you don’t want them to do this on your behalf.
Options are one of the most versatile tool you can use. There are dozens of different strategies you can use just by understanding these two basic building blocks — a call option and a put option. Once you’re familiar with them, you’ll find that they can be applied to any market condition.
Editor, Options Trader
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