You've finally bought some shares in a company, congratulations! And even better that company is doing exceedingly well now, and you're sitting on a tidy profit. Hooray! Unfortunately all that stress from market fluctuations is keeping you up at night, and you can't stomach the thought of losing all of that hard earned (cough ahem?) paper money.
So let's insure against that loss!
Insurance: the game that you only win when you lose
AAPL stock is currently trading at $487, and lets imagine for a moment you've been on
this wild ride for a while and purchased 100 shares way back at $200. You're sitting
on a paper profit of $28,700. You don't necessarily want to sell, but you're not willing to risk
all that profit either. One option open to you is to buy a put.
As the purchaser of a put option, you're buying the right (but not the obligation) to sell your shares to someone else at a pre-determined price by a pre-determined date. Let's run through an example to explain what this means.
AAPL current has a put option contract expiring on 17th of January 2015, with a strike price of
$400, and an option premium of $31.95. That means for a price of $31.95 per share, somebody will
promise to buy your shares for you between now and January 17th 2015 for a price of $400. The option
would only be exercised if the price of
AAPL drops below $400, any other time you're
better off selling the stock directly on the market.
As someone who is wanting to protect their investment it means for $3,195 (1 option contract x 100 shares x $31.95 option premium) you could guarantee that you could sell your shares for a $20,000 gain by locking in a minimum price of $400. You don't have to sell any of your shares, so you get to continue riding any upside.
That's a lot of cash
There might be various reasons why it's worth paying that premium to lock in a future price. For one, it might change the tax treatment on your sale and lower the amount of tax you pay. But it can also be a pretty pricey way to protect yourself. The example I gave is particularly expensive given how long-dated the option is, protecting against shorter-term price movements will always be much cheaper than this. The less chance of the option being exercised, the cheaper it will be. Obviously with a 17 month expiration there are a lot of unknowns that could come up, so they have to be factored into the price.