Practical Example Of How Stock Put Options Work

Put options are contracts that give the owner of a stock the right to sell them at a specified price and at a predetermined date. Here's how it really works.

When investing in the stock market, your job revolves around buying shares and selling them at the prevailing market prices. However, what if you knew of a way you could purchase shares at prices different from what exists at the time you want to?

This is pretty much the opportunity investors have with stock options. The general definition of an “option” in investment is basically any contract that gives you the right but not the obligation to purchase or sell a security on (or before) a specified date at a predetermined price.

When you have the option to buy a stock, this contract is known as a call option and when you have one that lets you sell a stock, you have a put option. However, if you have tried reading anything about put options without a finance background, chances are that you too might have gotten lost in all the technical jargon. Here’s how put options really work:

Why We Enter Put Option Contracts and A Practical Example

As said earlier, put options are contracts that give the owner of a stock the right to sell them at a specified price and at a predetermined date. The idea is that if you have some shares and you are bearish (that is you’re worried that the price will fall), you can purchase a put option to cut your losses.

In essence, you get to profit from a fall in the price of the stock instead of losing from it.

Let’s say you have 50 shares in a company at ₦10 per share. Based on your analysis of the stock market, you believe the price will fall, so you enter into an options contract to lock down ₦10/share.

Here, ₦10 serves as the strike price. As such, the option contract you have entered gives you the right but not the obligation (meaning you can back down if you want later) to sell those shares on or before a date you have predetermined with a given party that will buy.

If your predictions are correct and the price of the shares drop from N10 to N7, then you can make use of your option contract and still be able to sell the shares at N10 even though they are now worth ₦7.

As you can already tell, before this entire expedition can be worth it, the price of the security must move significantly below the strike price for you to make any gains from it.

Another thing you might ask is, “why not sell at ₦10 from the beginning?” I mean, if the idea was that you knew ₦10 could have been a safe sell, why wait for it to fall first.

Well, what if the price rose? If instead of falling to ₦7, the price of the stock rose to ₦12, you don’t need to sell again now do you? No! Because you’re not obligated to. On the other hand, the other party has something called a "premium" if you don't exercise your option, to gain. It means the premium is worth paying to cut your losses.

The profit you make is basically the difference between the strike price and the stock price. While there are charges that come with entering a put option contract, the benefits of cutting your losses for investors could be great.

It is important to note that strategies like this are used by traders who are not willing to wait out volatility. There is always the option to wait it out and see your investment average out into growth.

Written by Lawretta Egba.