Question

Explain how buying a put option is like insurance?

Answer 1

A put option gives its owner the right to sell a stock at a set price by a certain date. Buying a put option when you also own the stock (long put +long stock) is like buying insurance, or hedging against a possible decline, because the put option guarantees you a set sell price on that stock, if you want it, at a later date.

For instance, if you own 1,000 shares of XYZ, trading at $13, you could buy 10 put option contracts (each contract represents 100 shares of stock) to insure your entire position against further decline.It might cost you about $3 per share to insure a $13 sell price (strike price) on your Yahoogleazon! shares expiring in 7 months. So, even if XYZ declined to $5 during the next 7 months, the put option owner would be able to sell out at $13 – for a net sell price of $10 after accounting for the cost of the puts. If XYZ declines the next few months, and you still believe in its long-term potential, you can sell your puts for a profit and continue to own the shares.

On the other hand, if XYZ is $13 or higher by July (say it's $18), your $13 insurance policy won't have any value anymore. Like any insurance policy, it expires. Still, you were protected on the downside, and you still profited with the stock as it increased.