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Beginners' Guide To Put Options (Part 1 of 2) | What Are Put Options? - YouTube
Channel: The Joyful Investors
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Hello, welcome back to The Joyful Investors channel!
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Previously I had done a series of videos on understanding call options
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for beginners and I received many positive requests for
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another beginner’s guide on put options this time.
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So today here we have it, I’m going to be sharing about put options
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in a series of 2 videos!
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Before I kickstart with the put options guide, let me also quickly address
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this common perception of options that some of you might have,
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especially for those who are new to options.
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Are options for traders or investors?
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Options are short term plays that involve greater risks, so they are more for traders?
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Well, the answer is both!
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Both an investor and trader can use options to profit in the markets.
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The key difference is how to go about executing the trades
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and the type of strategies you use.
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As an investor, the mentality would be more about thinking how the use of options
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can complement our existing stocks portfolio
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and our investment thesis on the various stocks.
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Another example is that as an investor, never buy very short term call options
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that are expiring in just a few days from the date of purchase.
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There is more speculation involved.
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A very short time to expiration means that you have to be
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very accurate at predicting the direction of the stock price movement
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in order to profit from the option.
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Time decay is working against you as a buyer
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since time decay accelerates nearer to expiration date.
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So it really depends on how you go about using options for you as an investor.
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It does not necessarily have to be just for traders to use!
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With regards to the higher risks part, options may or may not involve higher risks.
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It all depends on how well you understand options,
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the options strategies and how you eventually go about executing the options.
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There is always this misconception that things which are more complex
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involve higher risk.
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But it actually boils down to your level of competency at managing the matter.
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Just like we don’t say flying a plane is more risky than driving a car.
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They are just different modes of transport and which one is riskier
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ultimately depends on the skills of the person who is steering the vehicle.
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Alright, so let’s begin with the put options guide!
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Put option is a contract that offers the buyers the right to sell an underlying asset
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at a predetermined price, known as the strike price,
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and within a specified time frame, known as the expiration date.
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Again, to be given the right to do that, the buyer has to pay a premium
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to the seller to compensate the seller for taking up the obligation.
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For example, assume today is 6 Dec 2021.
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The buyer of a put option has the right to exercise the put to sell 100 shares
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of Apple stock at $160 per share any time on,
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or before the expiration date of 7 Jan 2022,
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regardless of the market price of Apple by then.
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In exchange for this right to exercise the put option,
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he has to pay a premium of $540.
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Let me present to you the option matrix again.
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In the last series, I covered from the perspective of a buyer for the call option.
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For this new series, I’m going to cover from the perspective of the buyer of a put
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option to illustrate some of the key principles of put options.
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A disclaimer here. This is not a recommendation for any put option strategies.
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The guide is meant for beginners to understand put options starting off
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from the perspective as a buyer of the contract.
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To understand put options better from the perspective of a buyer,
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let’s take a look at this analogy.
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Suppose Jerry is considering whether to sell his house in Japan.
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The current value of his house has appreciated sufficiently such that
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he would profit if he sells off his house now.
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On one hand, he would love to continue to enjoy the appreciation
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in house value if the housing prices continue to rise in the future.
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On the other hand, he is afraid that upcoming developments near his area
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may cause the housing prices to fall and erode away his property value appreciation.
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Jerry knows of someone who seems interested in buying his house.
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Ben, though interested in buying the house, has not made up his mind yet.
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So Jerry thought of a plan.
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He told Ben, “How about I pay you a fee of $50,000 and in exchange,
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I have the right to sell my house to you any time within the next 3 months
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at a fixed sale price of $1,200,000.”
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Ben thinks this is a win-win deal for him,
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so he grabbed the opportunity and made the deal!
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In this analogy, Jerry is the buyer of the put option.
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He paid a premium of $50,000 for the put option in order to receive the right
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to sell his house at a predetermined price of $1,200,000
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with a grace period of 3 months.
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Ben, on the other hand, is the seller of the put option.
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He has the obligation to buy Jerry’s house,
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if Jerry approaches him to exercise his right any time within the 3-month period.
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Let’s explore what could have happened 3 months later and
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how it is going to impact Jerry, the buyer of the put option.
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Oh dear, there have been plans to build factories near the house.
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As a result, the housing prices in that area dropped to $1,000,000.
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Luckily Jerry had gotten the deal with Ben,
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so Jerry can still sell his house to Ben at the agreed price of $1,200,000.
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In this scenario, Jerry got a good deal by exercising his option to sell
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his house at $1,200,000 to Ben.
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Even though the market price has dropped by $200,000,
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he still gets to sell his house at $1,200,000 by incurring a cost of $50,000.
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Effectively, he is still $150,000 better off than the other house owners
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who choose to sell their house at the current market price of $1,000,000.
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Scenario 2: Hooray, the railway network is underway!
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As a result, the market price of a house in this location has increased to $1,400,000.
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However, it doesn’t make sense for Jerry to sell the house to Ben
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at $1,200,000 anymore!
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Jerry will be better off by selling the house off the market at $1,400,000,
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even after accounting for the $50,000 sunk costs.
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The total maximum loss Jerry incurs if he does not exercise the option
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will be the premium paid of $50,000.
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Buying put options act somewhat like an insurance.
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In the analogy, it was to protect the unrealised profits for Jerry
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by fixing the sale price of the house at $1,200,000,
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while at the same time, allowing greater potential profits in the future
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should the housing prices continue to increase.
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And of course to enjoy all these benefits,
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Jerry has to pay a fee of $50,000 in this analogy.
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This is similar to how put options work in the financial markets,
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except that the value of the put option will not stay constant at $50,000,
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unlike in the house analogy.
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In the next video, we will be sharing with you why the value of put options change
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and how it can affect the buyer of the put options.
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