Buying protective puts can be a very useful strategy when you are trading in the stock market. When the markets start to get volatile many traders will buy puts to protect themselves from the downside. It is actually a very simple strategy to learn and use.
If you want to understand how a protective put works the first thing you must understand is what a put option is. A put gives the holder the right to sell a stock at a given price on or before a given day. To get this right the put holder had to pay a small fee.
If you buy the $70 DEC put for stock ABC you can sell ABC for $70 on or before the 3rd Friday of December. This would be true even if stock ABC is trading far below $70 by that day.
Now how can you apply puts to protect you from a loss? I’ll show you. Let us say that you own a stock. It is currently trading at $73. The market has been volatile lately and you are afraid that your stock might go down lower. So, you want to protect the profits you have made in it. One thing you would be able to do is to buy the $70 put options for your stock. This would cost you about $1 per share.
Now if the stock goes down to say $62 you would be protected. Because you bought the $70 put option you have the right to sell your stock for $70, even though it’s only worth $62. You would only take a small loss of $3+$1=$3, as opposed to a larger loss of $11 if you didn’t buy the put.
There is a disadvantage to buying protective puts. You could have wasted your money when you bought it. For instance, if your stock went up or stayed at around the same price level then you would have lost $1. Your put expired worthless.
Some traders see buying a put as buying insurance, just like you would buy insurance on your car or house. If they need it then that’s great, if they don’t oh well at least you were careful.
Other traders will try to make up the cost of the put option by selling a call option. A call is the opposite of a put. When you buy a call you buy the right to buy a stock. So if you sell it you sell the obligation to buy a stock at a given price.
If after you bought the $70 put you sold the $75 call for $1 that would have offset the cost of the put. The only problem with this is that you would limit your profit. If you sold the $75 call for $1 and the stock went to $80 you would have to sell it at $75.
The protective put is an excellent way to protect yourself from a losses for a small fee. It can definitely be useful during times of uncertainty.
To find more information on how to trade in the stock market visit http://www.stocks-simplified.com
When I was young I wanted to learn how to trade the stock market. So I traveled around the country listening to professional traders talk about how they are making money in the market. After trading for a while I understand how easy it is to make money in the stock market and started a site http://www.stocks-simplified.com to help others learn.