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Combat stock market uncertainty with this “insurance” strategy

When a big market event is on the horizon, uncertainty is inevitable. Be it earnings season or the upcoming election, you need a way to protect yourself from volatility.

Put options may be just the solution.

Options get a bad rap. But, when you know what you’re doing, they can be great tools for your investing arsenal.

A few weeks back, I introduced you to call options—when purchased, these allow an investor to make a bullish bet on a stock.

Put options are the opposite. When bought, they allow a trader to bet on a stock’s downside. Today, we’ll cover the basics of buying put options, and how they work in practice.

How a put option works

I’ve found it’s easiest to think of put options like insurance. If you want to insure, say, a home, you need homeowner’s insurance to help cover costs in the event of damage. The money you pay for an insurance policy is called the premium.

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When buying a put option, you essentially pay a “premium” for the right to protect your stock. A put option gives the buyer the right to sell shares of a security at a specific price (strike) through a defined period of time (expiration).

Short-term options are usually three months or less, while longer-term options might expire after a year or longer. Typically, these long-term options have a higher premium than short-term options. And that makes sense. Back to our home insurance analogy, if you want to insure your home for three months vs. 12 months, the 12-month option will cost you more. 

Keep in mind that a put option is a bearish trade. It means you think a security is headed lower. 

For put options on stocks, one contract represents 100 shares. Now, you can buy a put option without being long the stock. But it’s easier to grasp the concept this way.

Let’s do an example.

A put option trade on Apple (AAPL)

Let’s say you purchased 100 shares of AAPL at $50, which has since risen to $100. But you’re worried about AAPL falling over the next three months—you want to limit your downside risk while protecting your gains. A $5,000 gain is great, and you want to keep it that way!

Let’s say today is January 22 and you’re looking for protection through April. Additionally, you aren’t willing to sell your AAPL shares for less than $100.

To protect your gains, you purchase one AAPL April 17 $100 put option contract for $5. This means until that April 17 expiration, your 100 shares of AAPL are protected below $100 (strike). In other words, you’ve insured your stock position!

Now, let’s run through some potential outcomes:

  1. AAPL shares keep rallying to $120 per share. In this example, your put option expires worthless and you lose your $500 ($5 premium x 100 shares). But, you participate in the upside with your 100 AAPL shares. You’ve made $7,000 on your long position ($120 – $50). Combined with your $500 loss on the option, your net gain is $6,500. 
  1. AAPL shares fall to $75. In this example, your put option is worth $25. You exercise your right to sell 100 shares of AAPL at $100, thus avoiding any downside on your shares. Keep in mind, you paid a $5 premium for the option, so your net gain on the put option is $20 ($25 – $5). You effectively sold your AAPL shares at $95 ($100 – $5).  
  1. AAPL shares do nothing and stay at $100. In this example, your option expires worthless and you lose $500 ($5 premium x 100 shares). You don’t gain or lose anything on the shares.

As you can see, options give you… well, options! But there’s a tradeoff to buying put contracts. There’s an upfront cost for the protection they provide. I like to call that the hurdle rate. Often, it’s a small price to pay to protect big gains.

This is a very basic illustration, but it shows you how rewarding buying put options can be. If you’d like to gain a deeper understanding of how options work, read my free Essential Options Trading Guide. And if you’re ready to take it to the next level, I have two options courses you can check out at Investopedia Academy.

Luke Downey is the co-founder of Mapsignals, which focuses on finding outlier stocks by following the big money. Luke is also an options instructor with Investopedia Academy. Prior to Mapsignals, he spent many years on institutional derivatives desks at Cantor Fitzgerald & Jefferies, LLC.

Editor’s note: Last week, Frank did something he rarely does: He recommended a put option trade to his Curzio Research Advisory members. To make it even more controversial, it’s a bet against one of America’s most beloved companies… And Frank thinks it could return 200% or more.

Access this trade today—and many more fantastic under-the-radar ideas—with a no-risk subscription to Curzio Research Advisory.

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