put options as insurance

the recent bull run brought many ‘Robinhood’ and ‘meme-stock’ investors in the market who seem to believe that prices go ‘up only’ but reality is different and the market can be ruthless when it decides to correct.

in a market which goes ‘up only’, what if there was a way to have insurance for your investments against sudden downturns?

It may sound absurd at first but there is a way to insure and cap one’s downside risk with an instrument called ‘put options’.

put options or puts, are contracts where the buyer has the right, but not the obligation, to short-sell a certain amount of a security or asset during a specified time frame and at a predetermined price.

one can create such a put contract for any asset like stocks, indices, currencies, bonds etc. and the value of such options rise if the price of the underlying assets start to fall.

this is how it works

say you bought 100 shares of stock XYZ at a price of Rs1,000/share. now the stock price can go up from these levels or it can fall. you don’t want to miss out on the upside potential but at the same time you want to limit your loss in case of a slide. to do so, you buy a put option of XYZ of the same lot size of 100 shares at a strike price of Rs 1,000 and a premium on top of it of let’s say, Rs100/share. 

two scenarios will play out from here on. first, if the stock price goes up to say Rs 1,050/share then you’ve made a total profit of Rs 5,000 on the 100 shares. in this case the price of the put option will also decrease, which is then set-off against the profit and you’re left with your net-profit.

in case the stock price falls to Rs 950/share, the value of the put option will increase, let’s assume it goes up Rs 20/share, then in this scenario your initial loss of Rs 5,000 on the 100 shares will reduce by (Rs 20 X 100 shares) Rs 2000, and the net loss will be Rs 3,000, lesser than without puts.  

when used properly, put options can act as a safeguard in one’s portfolio in what is known as a protective put strategy.