Personal Finance
Personal Finance
Purchase of Put Options

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When circumstances prevent you from diluting a concentrated equity position, you need a hedging strategy to protect the value of your investment should the stock price decline. At the same time, you'll want to be sure that you can share in the stock's upside potential. Put options can help you do both.

Buying a put option is like buying an insurance policy.
When you buy a put option, you receive the right to sell a stock at a set price on some future date. You are not obligated to exercise the option, but if the stock's market price has fallen below the sum of the put's exercise price and its cost, you'll certainly want to.

On the exercise date, you can sell your stock for the exercise price. If you're unable to liquidate your position for any reason, you can opt to receive a cash payment for the difference between the exercise price and the market price.

Here's how your "insurance policy" works.
The price you pay for a put option is called the premium, just like the price you pay for an insurance policy.

Let's say that your stock currently trades at $100 per share. You buy an option with an exercise price of $90 per share for a premium of $10. On the exercise date, the stock price has fallen to $70 per share. You can sell your stock for $90, and you paid $10 for the option to do so. You've realized a value of $80 per share ? $10 more than the market price.

Hedging costs can vary greatly. The longer the term of protection, the higher the put option's premium. Volatile stocks cost more to hedge as well. When you assume more downside risk, the premium falls. Depending upon your appetite for risk, you can choose the risk/return tradeoff that best suits you.