Put Options

We have seen in the previous post that a call option is basically an insurance contract protecting against a loss of capital by effectively stopping the loss to a determined amount, the premium paid to purchase the contract.

Now what about locking gains? Is there a way to pay a premium in exchange for the insurance that current gains will not be lost in the future? Such contract exists and it is called a put option.

Let's continue with the same example and say that John already owns 300 shares of GE and he has a gain at the current market price of $35.47. He likes the dividends that he is getting and he wants to hold on the stock. However, he wants to make sure that he is not going to lose his current gain if the stock were to go down in the future.

He is looking at an expiration date of the 3rd Friday of March. There are several put contracts available:

GE-OF with $30 strike price and a cost of $0.05 a share as of Friday at the close.
GE-OZ with $32.5 strike price and a cost of $0.15 a share.
GE-OG with $35 strike price and a cost of $0.7 a share.
GE-OS with $37.5 strike price and a cost of $2.4 a share.
GE-OH with $40 strike price and a cost of $4.8 a share.
GE-OV with $42.5 strike price and a cost of $7.2 a share.

Buying any of this contracts gives the right to sell to the contract writer 100 shares of GE at the given strike price before or on the third Friday of March.

Let's say that John has a gain of $7.47 a share because he purchased his 300 shares at a price of $28. Locking a gain of $7 a share by buying 3 GE-OG contracts will cost him $0.7 a share, with a certain gain of $6.3 a share. Locking a gain of $9 a share by buying 3 GE-OS contracts will cost him $2.4 a share, with a certain gain of $6.6 a share. Locking a gain of $4.5 a share by buying 3 GE-OZ contracts will cost him only $0.15 a share with a certain gain of $4.35 a share.

Of course, he will find convenient to exercise the option only if the actual gain on his GE investment will fall below the gain locked by buying the options before or on the expiration date. Otherwise, the premium paid to buy the options will be a loss, albeit small, effectively reducing is gain on the GE investment.

Here again we have the distinction between in the money options like GE-OS, GE-OH and GE-OV, at the money options like GE-OG, and out of the money options like GE-OF and GE-OZ.

Don't forget to check out my other blog exposing penny stock scams.

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