What are Put options?
A put option is an option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price (called Strike Price) within a specified time (called Time to Expiration). This is the opposite of a call option, which gives the holder the right to buy shares.
The investor can either buy or sell options. We will focus on selling options in this example.
Selling a Put option will obligate the investor to buy the stocks at the strike price if by expiration the current price of the stock is lower than the strike price. In this example, the investor is on the stock and already wants to buy them, but would prefer to buy them at a better price. If that's the case he can sell put options and receive a premium, until he gets assigned.
Let's say TraderX would like to buy 100 stocks of AXP ( American Express ), right now is trading at $100.96. TraderX thinks that the $96.5 level which is the monthly S1 would be a good resistance point and would like to get long if the stocks retrace back to that price.
TraderX can sell 1 Put option (1 option contract = 100 shares) with a strike price at 96.50 with 47 days to expire for a credit of $1.05.
If the Stock doesn't go back down during the next 47 days (Days to Expiration), TraderX keeps the $1.05 premium and makes $105.00 ($1.05 x 100). If it goes down below 96.50, the option is In The Money ( ITM ) and will get assigned at expiration. However, TraderX will keep the $1.05 credit regardless making his effective price or cost basis $95.45.
By using Options, the investor will get the following benefits:
1. Making profits, even if the stock never gets to his price.
2. Buying low, relative to the price where the stock currently is.
3. Improve his probabilities of profit. Since the investor is receiving a credit, the trade is no longer a 50/50 shot (In essence he get's a headstart).
4. Reduce his cost basis, since he keeps the Credit received (In this example $1.05, which is over 1% lower from his original price).
5. If the option expires, the Investor can just keep selling options and getting paid until he gets assigned, or no longer wants to be on the underline.