An Introduction to Put Options – The Motley Fool Singapore

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It is well known that Warren Buffett is critical of the derivatives market, believing that speculators and traders are misusing these tools. This is true for those who trade the derivatives market, looking to make a quick buck by moving in and out of the market frequently.

However, if used correctly, derivatives can, in fact, be a good way to hedge your investments or to obtain liquidity to increase your investment portfolio.

Warren Buffett himself has used an options strategy that allows him to earn in the longer term on a fairly consistent basis.

In light of this, I have decided to…

It is well known that Warren Buffett is critical of the derivatives market, believing that speculators and traders are misusing these tools. This is true for those who trade the derivatives market, looking to make a quick buck by moving in and out of the market frequently.

However, if used correctly, derivatives can, in fact, be a good way to hedge your investments or to obtain liquidity to increase your investment portfolio.

Warren Buffett himself has used an options strategy that allows him to earn in the longer term on a fairly consistent basis.

In light of this, I have decided to write a three-part series on how we, as investors, can benefit from using an options strategy.

This is split into (1) Call Options, (2) Put Options, and (3) Using options as an investment strategy. This is part two of the series.

Put options

Put options are a contract between two parties that give the buyer the right but not the obligation to sell a share at a predetermined price known as the strike price. An investor who thinks that the stock price is going to drop might want to buy the put options as he can make a profit if the share price goes below the strike price.

As usual, on the other end of the deal, the seller or writer of the put option is obligated to buy the share at the predetermined strike price if the contract is executed. The deal involves a premium fee, which the buyer pays to the seller to give him the rights to the contract agreement. The seller of the contract, regardless of the contract being executed, pockets this premium fee.

Example

Mr Tan buys a put option contract for Company Y with a strike price of $100, and it expires in one month. If at the end of the contract, the share price of Company Y is at $90, Mr Tan will execute the option contract and sell the company at $100 and buy back the shares at $90 meaning he made $10 per share.

On the other hand, if the share price goes up to $110, Mr Tan will not execute the option contract and allow it to expire worthless. He would have lost the premium, which he paid to the seller of the contract.

The premium Mr Tan paid to obtain the contract is determined by the time value of the contract and how far the strike price is to the current price of the stock.

The Foolish takeaway

Derivatives have had a bad reputation in recent years, as speculators and traders pour their money into the market without actually knowing the risks. As investors, we should be aware of the risks of each asset that we are investing in and understand the mechanics of how it can affect our portfolio. Now that we know how both put and call options work, I will next look into how long-term investors can use options to maximise their long-term returns.

Meanwhile, for more (free!) investing insights, sign up here for your FREE subscription to The Motley Fool’s investing newsletter, Take Stock Singapore. It will teach you how you can grow your wealth in the years ahead.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Jeremy Chia doesn’t own shares in any companies mentioned. 

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