WTF (Wait That’s Finance) Part II: The Down and Dirty on the Naked Put

call option, options picture, futures marketOk not really about the naked put, but now that I have your attention we are going to talk about put options in general.  Go ahead and check this post out on derivatives to get up to speed.  Wait make sure that you come back.   Are you up to speed now?  Today I decided to take an in-depth look at the put option and try to explain it in layman’s terms.  Sure I cannot cover every possible scenario in this post but I hope to explain it to you and give you a better understanding so next time you hear it you will be able to chime in with your 2 cents. 

The put option is a strategy that is seldom talked about among individual investors, but it is a strategy that is popular among savvy investors and options traders.  The put buyer pays a premium to the seller for the option to purchase the underlying security. (no pun intended, ok it was!)

What is a put option? 

A put option simply is an option that gives the buyer the right, but not an obligation, to sell the underlying security at a certain price and certain time.  If the buyer decides to exercise the seller of the put option has to purchase the underlying security at the strike price if the buyer exercises the option.  The put option is sold in 100 share increments.  American put options can be exercised any time prior to the expiration date.  The expiration date for American put options is the third Sunday of every month.  Confused? Great I will provide an example later. 

Why would you enter into a put option?

A buyer thinks the price of the security will decrease by the exercise date.  The buyer pays a premium.

A writer/seller thinks that the price of the underlying security will increase and collects the premium

Example of a Put Option:

Groupon is currently selling for $11.96

With all the bad press recently that Groupon has received, we expect the price of the shares to decline.  We buy a put option with a strike price of $11.00.  We would start to make a profit once the price of the shares falls below $11.00.  We are trying to catch the profit off the downward movement of the underlying security. 

Trading this type of financial instrument we are using leverage, while this situation we anticipate a positive outcome, there can be severe consequences using any type of leverage.  It is best to seek out a financial advisor before using options on your own. 

Class are you ready to explore put options on your own?  Have you had any practice trading options on your own? Were you successful at it?

PHOTO BY: yojspew
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Comments

  1. 90% of options traders lose money. The only people who make money are those who write the options. The biggest obstacle to making money in options is the time value. In your example, if Groupon is at $11.96 and you pay 50 cents for a May put option with an $11 strike price, the stock has to fall to $10.50 by the third Friday in May just to break even. Option buying is a suckers game.

  2. Great article. Options are not the easiest to understand but they saved me a lot of money during the market crash in 2008.

  3. Well this makes me a feel like a dumbass in the investing game. I know so little that this post went over my head a bit lol. It doesn’t sound like a strategy that I’d want to get involved in, especially if 90% of these kinds of investments lose money like the comment above mentioned.

    • @ Jeremy – it is ok, we all feel like a dumb ass at times. Some more than others lol….I have never traded options because we didn’t have any spare money laying around where I could take a risk.

  4. Oh man, this stuff is almost over my head, but I think I understand what you were saying here. Posts like these make me wonder what my wife and I have happening in the investment department and what kinda options we’re using.

    • This is over my head too. I am trying to grasp the concept but not sure if I’m really understanding it.

      • @ Katie – don’t worry it was probably over most heads by so few comments. 🙂 Options are a difficult topic to cover in a short post. They are often risky, and if you are not well versed in them I would avoid them. There are a lot of varieties of options too.

    • @ TB – In the investment department, you may want to sit down with your advisor and have them explain everything to you. It is critical that you understand what you are investing in, for all you know they could be taking your money and playing the roulette wheel and just randomly picking things. You work hard for the money so you should know.

  5. That is how smart people make money even when prices fall. I remember one such example from a Bond movie – “Casino Royale” where Le Chiffe (the bad guy) buys put options of an airline and then plans to bomb an airplane of that airline. This would cause the airline stocks to fall and he would make lots of money. Obviously James Bond spoils his plans and the put options expire causing huge financial loss to Le Chiffe.
    Moral of the story – options are risky. Use them to reduce your risk but not for speculation or quick money

    • @ Karunesh – very good movie I am quite fond of mr bond. Interesting too is that you are a world a way and you enjoy similar movies… enjoy your weekend!!!

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