How do put options work in finance? what do buyer/sellers get out of it?
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Options are intended to be used as “insurance” but they can also be used in speculative and leveraged investing strategies.
Let’s say you own 100 shares of XYZ valued at $100. You’re OK if the stock goes down a little but you can’t really afford for it to go below $90. You could set a stop loss order but that won’t do you any good if the price gaps down below $90 at the market open or if there’s liquidity issues in executing your order at $90. It can also go back up right after and you’d lose out on the recovery. The solution would be to buy a $90 Put option. This will give you the right, but not the obligation to sell your shares at $90 until a specified expiration date in exchange for a premium. If the stock tanks and goes to $0, you will still have the contractual right to sell your shares at $90. If the stock drops to $80 but then recovers back to $100 you do not have to sell at $90 and can continue holding on to your shares.
On the flip side you can use a call for similar measures. Let’s say XYZ is currently trading at $100. You want to buy 100 shares of XYZ but you don’t have the moneg ready yet. You can then buy a call option at $100. This gives you the right but not the obligation to buy 100 shares at a price of $100. So if the stock goes up to $120 before you’re able to buy the shares, you won’t have to miss out on the gains since you will have the right to still buy in at $100. If the stock falls below $100 you aren’t obligated to buy in. From a speculation standpoint, you could buy call options if you want to speculate on the stock going up. Let’s say March options for $100 are trading for $5 in January and you buy one, if the stock goes to $120 by expiration in March, then you can sell the option for $20 and make 3x the original investment even though the underlying stock only increased by 20%.
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