Put Options are used extensively by investors as a way to hedge their stock portfolio, much like Call Options, Put Options are legally binding contracts, except that Put Options that grant the buyer the right to SELL 100 shares of a stock, at a predetermined (Strike) price, and they are used by investors who believe or fear that there might be a drop in the underlying stock price!
Payout diagram of the Put Option
Put Options are used extensively as a way of hedging a stock portfolio, even though a single Put Option contract is said to control 100 shares of stock you cannot fully protect those 100 shares with a single Put Option contract. As you will find out while learning about Options, the Option’s Delta parameter is what determines how much your Put Option will gain in value while the stock drops by $1. This means that in order to fully protect 100 shares of a stock from a possible decline, the investor has to buy either 2 Put Options each having a Delta parameter of 0.5, or one Put Option, very deep in the money (And very expensive), with a Delta close to 1. It depends on the objectives of the investor, sometimes they just fear a short term pull decline in the stock market (A correction) and they just want to profit from it, but sometimes they fear the possibility of a more severe decline where the stock may not fully recover. In the case of the worst decline where serious financial loss is feared the investor may choose to apply 100% protection (Delta = 1), using either 1 or 2 Put Options.
Delta means a lot
So why not protect my stocks with 2 cheaper Delta=0.5 Put Options rather than one single, expensive (Delta=1) Put Option? The expensive, deep in the money Put Option will have zero extrinsic value and therefore will suffer almost zero loss as time passes, neither will be affected by adverse volatility shifts, whereas the 2 cheaper Put Options will be affected! It all depends how accurately one can predict the decline in the markets, if you are just worried that it may happen or if it’s already started to happen and you are smart enough to spot the signs.
Put Options are great way to limit losses when markets go down, it is believed that investors who lost everything in the tech bubble collapse of the late 1990s could have saved at least 50% of their money, while spending too little for Put Option protection. They could have saved this 50% even with the worst performing Put Option trades!
