Warren Buffet has made no secret of his successful investing strategy. “Buy into fear” he says, “Buy when everyone else is selling”. For most, average investors that may be much easier said than done. Perhaps if we all had a few billion dollars in the bank, we might be able to muster up more courage and take some more risks. The fact is, however, that anyone can make money in bull markets; he has become a billionaire buy investing aggressively in bear markets. If all he did was buy stocks that were already going up, he wouldn’t be anywhere near as wealthy. Instead, he buys stocks on the way down realizing that, when they do start to rise again, there will much more profit potential. That takes some courage.
If you don’t have the courage to “invest like Buffet”, you could consider buying stock loss insurance which will provide you with downside protection against a decline in a stock’s price. You know about insurance – it’s what you buy to protect your house or car against damage or loss. You pay a premium, and when you suffer a loss, the insurance company makes you whole. While it’s possible that you could pay premiums for many years and never have a loss, the insurance gave you the confidence to own expensive assets because you were protected. Stock insurance, in the form of put options is very much the same.
What exactly is a Put Option?
A put option is a contract between the buyer and the seller of an option that obligates the seller to buy the underlying stock at predetermined price (strike price) at a specific time (expiration date) in the future. The purchase price of the option is based on how close its strike price is the actual price of the stock at any particular time. If the stock’s price is below the strike price, the option is “in the money” which means it will sell at a premium. The further out the option is from the expiration date, the higher the premium. Conversely, a put option with a strike price below the stock price is “out of the money” so, the premium will consist largely on the time element.
As the price of the underlying stock falls, the premium value of the option increases, so, conceivably, even though the underlying stock declines in value, the increase in the put option’s premium value offsets the stock’s loss. If the stock price does drop, the holder of the put has a number of options available. He can hold the put until it expires at which time he can exercise his option to sell the underlying stock at the strike price which is higher than the actual stock price. If he intends to hold the stock longer, he could just let the option expire worthless and then buy another put option for an extension of his stock loss protection. At any time prior to expiration, he could also sell the option for a profit (as long as it has premium value), and buy another option with an extended expiration date.
On the other side of the coin, if the stock price increases above the strike price, the put option’s premium value will decline. And, as the expiration date approaches, the premium value will decline even further. On the expiration date, the option will expire worthless. Because it is out of the money, the put he would not want to exercise his option to sell the stock at the lower strike price. If the stock continues to increase in value, he could decide to hold off buying another put option until he thinks the market might turn down. Or, he could go ahead and but the put option for added peace-of-mind. He will only be out the premium he paid for the option.
Your Put Option in Action
Here’s an example of how a put option works:
You own 100 shares of ABC, Inc. stock which is currently valued at $28 dollars a share. To add some courage, or downside protection, you pay $1.50 to buy a put option for ABC that has a strike price of $25 per share. Because the minimum number of shares an option can cover is 100, you actually pay $150. So now, at any time the share price of ABC trades below $25 per share, you have the right to sell those shares at $25. The premium value of the option is fairly low because it is out-of-the-money (share price is above the strike price) and the expiration date is just three months off.
If the share price drops to $20 per share, the premium value of the put option would be worth at least $5, and if the expiration date is a ways off, it will be worth more. If, at that point, the premium value of the option was, say, $7, you could sell the option for a $5 profit. If the stock price remained at $20 until the option’s expiration, you could exercise the option and sell the stock at $25 per share. In either case, you have limited your losses. Or, you could invest like Buffet and hold the stock forever.