CHAPTER 7
Long Puts
For most traders, call option strategies are more intuitive and more readily understood than put option strategies. We'll ease into the concepts by comparing the rights of a call buyer with the rights of a put buyer. Buying a call option involves the right to purchase shares at a specific price for a fixed amount of time. Unlike a call option, where the buyer has the right to purchase a stock, the put buyer has the right to sell a stock at a specified price for a fixed amount of time.
GETTING TO KNOW THE STRATEGY
For investors with shares of a stock or exchange-traded fund (ETF) in their portfolio, puts can be used as a way to protect against downside risk in much the same way that insurance policies protect home and auto owners against property losses. Because put contracts share similarities with insurance policies, we will start to explain the concepts on that basis. Let's say a homeowner buys a vacation property on the coast of a low-lying island in the Gulf of Mexico for $300,000. He recognizes the potential for a hurricane to devastate the property, so he purchases insurance to protect the full value of the structure for $300,000. For this insurance he pays a premium of $3,000 for one year's worth of coverage with zero deductible.
During the first year of ownership, no hurricanes hit the island and, therefore, there's no damage. His insurance policy expires unused and worthless. The homeowner renews the policy for a second year of coverage at a cost of ...
