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Explore Your Options - Part Two

Peter Katevatis - Jul 07, 2015
With the dog days of summer approaching, this is a great time to slow down and learn something new about the markets and investing.  In Part One of the Explore your Options series we reviewed the basic Call option, also known as, the right to buy.  I

With the dog days of summer approaching, this is a great time to slow down and learn something new about the markets and investing.  In Part One of the Explore your Options series we reviewed the basic Call option, also known as, the right to buy.  In this post, we are going to review the Put option which is the right to sell.

 

Katevatis Wealth Management - World Markets

 

Even though it is the opposite of a Call option, many individuals have some trouble understanding the Put Option concept.  Let me put (pun intended) this simply, you would buy a put either to speculate a stock will go down in value or to insure the stock you hold does not go down in value.

 

Like a Call option, a Put option has a duration (expiry date) and a strike price (price at which shares can be sold) to meet your specific needs.

 

Let’s discuss this specific example:

 

You like using the iShares Energy ETF (XEG) as a proxy for Canadian energy companies since it consists of 53 companies.  You believe that the recent weakness in oil prices, and potential future weakness in oil prices will cause Canadian oil and gas company share prices to decline further.  To profit from this fall in price, you can buy a Put option on XEG.  This can be considered as a stand-alone trade or as insurance to cover the decline of a long position in other oil companies or XEG.

 

Most people are familiar with the traditional method for making profits on a downward move in prices by short selling the security.  You can still short a stock, but it has several drawbacks to a Put option, specifically it ties up more of your capital and you have the risk of losing money if the share price goes up instead of down!  A short position also has the risk of being bought in which cannot happen when you are long a put option.

 

By purchasing a Put option you control your bearish position and only cash in if you can make a profit.  Therefore, if the market price on the equity you hold is above the strike price on maturity, your option will expire worthless. You cannot lose more than the cost of your put option.

 

A buyer of a Put option is in some ways buying and insurance policy against the market declines.  And when there is turmoil in the world (Greek debt crisis, terrorist threats, economic uncertainty) a little insurance* can help smooth out the violent swings of the market.

 

*If you are looking for regular insurance, not put options, Insurance and estate planning services are offered by Canaccord Genuity Wealth & Estate Planning Services Ltd.