Heads, You Win. Tails You Don't Lose Much.

Apurva Sheth
What do the Patel community, Richard Branson, and LN Mittal have in common?

Ace investor Mohnish Pabrai points out that all three focus on not losing much if things don't work in their favour. They have minted billions by minimizing their downside so that the upside can take care of itself.

This is the success mantra of many investors like Warren Buffett and Joel Greenblatt. They only invest in securities when they are confident that, if they are wrong, they won't lose much.   

But what about the common investor? He may not be able to identify that kind of stock. Even if he thinks he has the perfect stock that won't go down much, uncertainty remains.

Fortunately, financial instruments are available to safeguard the common investor from uncertainties.

A put option is an instrument that helps you safeguard yourself from uncertainties.

A put is an option that gives the buyer/holder the right - but not an obligation - to sell a security at a particular price within a specific time period.

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We will leave that 'text book' definition for the purists.

Let's understand put options at a basic level. Don't worry. I will keep it simple and easy, just like last time when I explained call options. So if you have gone through the previous article and understood a call option, then I don't see any reason you won't understand a put option.

You might be surprised to know that you've probably already bought a put option.

Tell me, have you bought a mediclaim or health insurance for yourself or your family?

If yes, then you have traded a put option.

A health insurance policy protects you against the risk of incurring medical expenses in the event of illness. This policy is an agreement between you and the insurance company. The company agrees to compensate you for medical or surgical expenses incurred during the illness up to the sum insured.The sum insured is the maximum amount your insurance company will pay in the event of illness.

The company agrees to cover this risk worth the sum insured by charging a fee. The fee is known as - premium. It covers this risk for a specific time - usually one year. After a year, you have to renew the policy by paying the premium again.  

You have probably bought health, vehicle, or travel insurance in the past. A put option is like an insurance policy you buy for a stock. It will protect you from losses if the stock goes down.

Just like the insurance policy, you pay a premium to buy the put option, which is valid for a specific period.

If you fall ill during the insurance period, then you can rest assured that the company will reimburse the medical and hospital expenses up to the sum insured.

Similarly, with put options, if the stock/index falls beyond a certain price, then you can rest assured that the seller of the put option will pay you. The amount that he pays depends on how far the stock/index falls beyond the point that you and the seller agreed upon at the purchase of the put. The exchange acts as a guarantor to both the buyer and seller of the put options. 

On the other hand, if you don't fall ill and do not incur any medical expenses during the year, then the policy expires unclaimed and the insurance company keeps the premium for that year.

Similarly, if the stock/index doesn't fall beyond the agreed-upon price, then the seller of the put option keeps the premium you paid him when you bought the put.

In this example, the buyer of a put option is like an individual who is buying an insurance policy and the seller of the put option is like the insurance company.

Simple, isn't it?

If you have any queries about put options, you can write it to me. Meanwhile, Asad just announced that he will reveal how his options strategy works through a Master Series.  

What do you think of put options? Share your views in the Club or share your comments here.

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7 Responses to "Heads, You Win. Tails You Don't Lose Much."
Bimal Kundu
28 Jun, 2017
Where can we find the list of all optionable stocks, MFs and their premiums with the various expiary dayes ?Like 
15 Sep, 2016
i see post perfomanceLike 
04 Jun, 2016
vERY NICE PRESENTAATION , associted always with commercial approach give us immense pain.Like 
hoshang dehnugara
02 Oct, 2015
very lucid and clear example, but pl explain further if any riders are attached as to a novic like meLike 
01 Oct, 2015
thank you so much for clarifying call and put so simply since one year I was unable to understand with easy examples. but still in the put option wy d seller will loose if d shaevalue goes down and how he will make good d loss. hope you will calarify rgdslLike (1)
01 Oct, 2015
Very well explained. Some concrete example in another article with tit bits will be further beneficial.Like 
30 Sep, 2015
Very good explaination of put. Put buyer have to understand the time decay is main problem for buying put. As the time passes Put premium value goes down. Like 
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