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Let’s say that you are a real estate investor and you own a piece of vacant land. Let’s also say that you’re concerned that over the next 24 months real estate prices in your area are likely to decline by as much as 15% to 20%. Also, that the land has been in your family for over 50 years and you just can’t bring yourself to sell it. And let’s say that a banker friend of yours gives you the name of a company that sells insurance policies to land owners that will protect you from a loss should prices decline.
After several discussions with the insurance company you decide to purchase a ‘loss protection policy’ that would cover any declines in the value of your property up to 20% of today’s value during the next 24 months. Let’s say that the current market value of your property would cover up to $100,000 of lost value. And that the price for this insurance is $8,000, which we will refer to as the ‘premium’.
Now, let’s move the clock forward 24 months and real estate values have in fact declined, but not as far as you thought. They’ve declined by only 5%, not 15% or 20%. Your $500,000 property is now worth $475,000. Because you’ve experienced a loss in market value of $25,000, the insurance company covers your loss and you receive a check from them for $25,000. Thus, for a premium of $8,000, you managed to avoid $17,000 of additional losses.
This same type of ‘insurance’ is also available to the owner of other assets such as stocks or futures contracts. For example, let’s say that you inherited 1,000 shares of Apple Computer which was purchased in the very early days that Apple became a publicly traded company. Because of the taxes that would become due from the profits you have compounded through the years, you decide to speak with your financial advisor about a loss protection policy. In the world of options trading, this type of insurance is referred to as a ‘put option’.
A put option gives the buyer (in this case the buyer is you), the right but not the obligation, to sell the underlying asset at a predetermined price for a specified period of time. In our real estate example, let’s say that after 15 months of the 24-month contract, the market value of your property has dropped by 10% and you decide to sell the property at a loss and make a claim against the insurance company. After the 10% loss, your $500,000 property sells for $450,000 and you receive a check from the insurance company for $50,000. As a result, for a premium of $8,000, you were fully protected against a loss of up to $100,000.
But, what would happen if the value of your property had declined to $380,000? At the time of sale, you’d have taken a loss of $120,000. Because your policy only covers losses up to $100,000, you’d have had a real loss of $20,000, plus the $8,000 that you paid for the option premium.
In the case of your 1,000 shares of Apple Computer, the price of your insurance would depend on several things:
The strike price of the put option. Remember, the strike price in these examples is the price that the buyer and the seller of the option contract agree is the current market value of the asset. In the case of the $500,000 piece of property, the strike price would have been $500,000. In the case of Apple Computer, let’s say that the current price of the stock is $90 a share. To fully insure the 1,000 shares, the strike price of the put option would be $90.
The second item is the period of time for the option contract. In other words, when does the option contract expire? In the case of Apple Computer, we want insurance that would cover a loss during the next 24 months. Therefore, we want to buy a put option that would not expire for at least 24 months from today.
The third item is price volatility. A discussion of price volatility can become complicated, but a simple explanation is that when price swings are mild (or minimal) and prices remain somewhat steady, price volatility is not too important and it has very little effect on the price of the option. But, when prices are changing very rapidly from one day to another, the price of an option will be much higher than it would be during quiet times.
For this example, let’s say that a put option that would prevent any loss whatsoever in the value of the 1,000 shares of Apple Computer, is currently trading at 30 points.
Remember, an option contract is equal to 100 shares of stock. Therefore, a put option trading at 30 would cost $3,000 ($30 times 100). But one put option contract would only cover losses for 100 shares of stock. In order for you to fully protect the 1,000 shares, you’d have to purchase 10 put option contracts. Your total cost of insuring your 1,000 shares of Apple Computer against any loss for a 24-month period would be $30,000.
If this seems kind of high, you’re right, it’s very high. As we mentioned earlier, the price of an option contract is determined by ‘the market’. The market is made up of other traders around the world that are interested in purchasing this same option. In order for any trader to buy this option, they have to ‘bid’ for it (or specify a price that they’re willing to pay). During times of less price volatility, this same put option in Apple Computer could easily trade for around half of this price or $15,000 for 10 put option contracts.
Is this insurance really worth $30,000? It is if the price of Apple’s stock declines from $90 a share to below $60 a share in the next 24 months. Let’s look at a few ‘what ifs’.
In this example, the $30,000 would be the option premium. If the price of Apple Computer declines to $70 a share on the day that the put option expires, the loss in your stock would be $20 a share or $20,000. Because you own the put option, the value of your put option would also be $20,000. As long as the price of the stock is below $90 a share, the value of the put option will be equal to the loss in the stock. So, if the stock is trading at $70 a share at the time the put option expires, the loss in the stock would be offset by the value of the put option. But because of the price you had to pay for the insurance (the option premium), you’d still have a loss of $30,000.
Now let’s say that the price of the stock declines from $90 a share to $35 a share, resulting in a decline of $55 a share in the stock. If this would occur, the loss in the stock would be $55,000, but because the value of the put option would also be $55,000, your loss would still be limited to the cost of the option (in this case $30,000). A decline in the value of the stock by any amount is protected by the put option.
Now, instead of declining in value, what would happen if the price of the stock goes up to $125 a share, resulting in a gain of $35 a share? Because you own 1,000 shares, your profit would be $35,000. Because you purchased the put option to protect you from any type of loss in the stock, the put option would have no value at all. In other words, it would be worthless and your loss on the option would be limited to the option premium of $30,000.
If you own a stock, you can purchase insurance in the form of put options. You can protect either a portion or all of your investment in the stock depending on the strike price that you choose.
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