Understanding how put options work could be a difficult concept to grasp, so here is an example so you can better understand this concept.

Imagine your employer is relocating you to a different country and you need to move in 6 months.  But, here’s the thing – you own your home and need to sell it when you move.  The current value of your home is $300,000, but you don’t want to sell it immediately because you still need a place to live for the next 6 months.

Instead of selling it immediately, you approach the local real estate tycoon with a special deal.  You tell him that you want to pay him $20,000 for the right to sell him your house for $300,000 anytime in the next 6 months.

The local real estate tycoon accepts your offer and gives you the “option” to sell your house to him at the “strike price” of $300,000, as long as you pay him a “premium” of $20,000.

The real estate tycoon thinks your home will go up in value and figures that he can turn around and sell your house for at least $300,000 and pocket the $20,000 premium that he collected from you.

Now fast forward 6 months.  Your employer is ready to ship you off to a distant land and it’s time to sell your home.  Here are a couple of possibilities:

Scenario 1 - Home values in your area rise and your house is now worth $400,000.  Yes, you have the option to sell it for $300,000, but why would you?  Instead, you sell the home in the open market for $400,000 and let your “option contract” expire worthless.

Scenario 2 - Home prices in your area plummet and your house is now worth $200,000.  In this case, you would exercise your “option contract” and sell your house to the real estate tycoon for $300,000.  He won’t like it, but it’s his problem now.

That was a real world example of purchasing a put option contract.  This “option” gives the right to sell the house at a certain price – anytime up to a specified date.

Purchasing a put option contract on a stock is very similar.

For example, if you think a stock trading at $20 will go down, you can purchase a put option contract to sell the stock at a specific price anytime until a specific date.  For a $2 per share premium you purchase one put option contract and acquire the right to sell 100 shares of the stock for $20 per share until the third Friday in January.  If the stock drops to $10 within your allotted time frame, then you still have the right to sell it for $20.

Essentially, you could exercise your option and short-sell the stock at $20 and buy it back at the current trading price of $10.  Subsequently, you would make $10 per share, minus the $2 premium you paid, which equals an $8 profit.  One options contract controls 100 shares of stock, therefore your profit would be a minimum of $800.  Most times you don’t ever exercise your options and take a position.  I just went over exercising so you can understand the mechanics of put options.

Keep in mind that if the above scenario panned out, you would want to just sell your options in the open market and make $800 or more in profit.

See how simple put options are?  If you think that a stock will go down then consider buying a “put option” which could profit nicely as the stock falls.

Best Wishes,

Ted Peroulakis

P.S. My new options newsletter, the Options Power Trader recommends put options on companies that I believe are overvalued.  It’s not uncommon to make 100% or more as a stock falls, as long as you have the right put options.  Click here for more details.