How a Put Option Trade Works
Put options are bets that the price of the underlying asset is going to fall. Puts are excellent trading instruments when you’re trying to guard against losses in stock, futures contracts, or commodities that you already own.
Here is a typical situation where buying a put option can be beneficial: Say, for example, that you bought XYZ at $31, but you start getting concerned, because the stock price is starting to drift down because the market is weakening.
A good way to protect yourself when you’re in this situation is to buy a put option. So you decide to buy an August 30 put for a $1 premium, which costs you $100.
By buying the put, you’re locking in the value of your stock at $30 per share until the expiration date on the third Friday in August. If the stock price falls to $20 per share, you still can sell it to someone at $30 per share, as long as the option has not expired. Indeed, the put option gives you the right to sell the stock at $30 no matter how low the price falls.
Using the put option as portfolio insurance fixes your worst risk at $200, which includes the $100 premium you paid for the put option and the $1 per share you can lose after originally paying $31 per share for the stock, if you exercise the put.
Your other alternative when the stock falls below $30 is to sell the put to the market and profit from the appreciation of the option while holding onto the stock.