🔍
Beginners' Guide To Put Options (Part 2 of 2) | Why Does The Value Of A Put Option Change? - YouTube
Channel: The Joyful Investors
[3]
Hi welcome back!
[5]
Before we begin, let’s do a recap of what we have covered in the part 1 video.
[11]
In the previous video, I shared with you guys about how Jerry made use of
[16]
the concept of put options as a way to ‘protect’ the profits for selling his house.
[23]
In that analogy, the put option that Jerry bought is valued at $50,000
[29]
and this value stays constant at $50,000.
[33]
But in the financial markets, the value of put options does not stay constant.
[38]
Let’s get down to some of the factors that result in the change in value
[42]
and in the second part of this video today I will also be talking about
[46]
why investors may want to buy put options.
[50]
On 6 Dec 2021, the share price of AAPL is $160.
[56]
Suppose you think that Apple share prices have already rallied up by a lot
[60]
and you are afraid that the share prices may fall,
[63]
so you decide to buy a put option as a protective hedge for your Apple holdings.
[68]
Take note that this is just a theoretical scenario to teach the concept of put options,
[73]
and I’m not implying that Apple share prices are going to come down.
[77]
So you have 100 AAPL shares in your portfolio currently
[81]
and you purchased a put option for AAPL with a strike price of $160,
[87]
expiring on 7 January 2022.
[90]
1 contract for options is for 100 shares,
[93]
so for this put option, the total premium you have to pay is $540.
[100]
Which means that currently, the value of this put option is $540.
[106]
One of the factors that affect the value of options is
[109]
the movement of the share price in relation to the strike price.
[113]
Let’s say the share price of AAPL decreases to $150 1 week later.
[119]
How will the value of the put option change?
[122]
The value of the put option in this case will now increase!
[126]
As an arbitrary figure, let’s just say the value of the put option increases to $1,150.
[134]
You may ask, why did the value of the put option increase?
[139]
From the perspective of a buyer, you want the price of Apple shares to
[143]
decrease below the strike price of $160 so that you are getting a good deal
[149]
by fixing the selling price of the apple shares at $160
[154]
should you decide to exercise the put option.
[156]
In other words, you get to sell your apple shares at $160
[161]
while the other investors can only sell them at $150 market price,
[166]
that makes you better off than the other investors without the put option.
[171]
So this makes the put option you hold more valuable now!
[176]
The converse is true as well.
[178]
If the price of apple shares increases to $170 a week later,
[183]
the value of the put option declines to $180.
[188]
Since you are better off by selling your Apple shares at a price higher than the
[193]
$160 strike price directly off the stock market,
[197]
this put option is no longer that valuable to you now.
[201]
In terms of the technical definition,
[203]
this is what we call the intrinsic value for a put option.
[207]
The intrinsic value of a put option is the value you get by
[211]
taking the strike price minus the market price of the stock.
[216]
When market price declines to below strike price,
[219]
intrinsic value becomes a positive number.
[222]
Then, when the market price increases up higher than the strike price,
[226]
intrinsic value declines to zero.
[230]
Another factor which I mentioned before that affects
[233]
the value of an option is the time decay.
[236]
As time decays nearer to the expiration date,
[239]
the value of the put option declines.
[241]
This is because you have less time and less potential for the share price
[247]
to move in the direction that is in your favour.
[250]
Which in this case, is for the share price to decrease below the strike price.
[255]
Time decay also makes up part of the extrinsic value of the put option.
[260]
Now that you have a better understanding of how and why
[264]
the value of put options fluctuates,
[267]
let’s look at how investors can benefit from buying put options.
[273]
Before I continue, this video is for educational purposes on
[277]
understanding the concept of put options from a buyer’s point of view and
[282]
it should not be construed as a recommendation of any option strategies.
[288]
The first reason is to hedge your position in the underlying shares.
[293]
This works just like insurance where you pay a premium
[297]
and you get insured for a certain amount.
[300]
When you buy a put option, you lock in the selling price of your shares
[304]
at a price level which you are comfortable selling at,
[308]
while at the same time,
[309]
you continue to enjoy potential increase in profits if the share price increases.
[315]
The maximum loss you will incur is the premium you pay for the put option.
[321]
In the case of the Apple stock example in the previous video,
[325]
you are paying a premium of $540 to insure or protect $16,000 of Apple stocks.
[335]
When would investors want to do this?
[337]
Usually investors may buy a put option to protect their portfolio during times
[344]
when they think that a crash or a price decline is imminent.
[349]
But of course, they could be wrong about the price decline
[353]
and the price ends up going up,
[355]
so they get to continue to enjoy the increase in capital gains
[359]
by holding on to their shares and the costs they pay is the put option premium.
[367]
This could be a strategy to take when investors are holding on to
[371]
at least 100 shares of a particular stock and so they buy a put option of that stock.
[378]
Another way investors can go about using put options as a buyer
[383]
is to buy a put option on the ETF that tracks the market
[388]
that they are mainly invested in,
[390]
for example, a put option of the SPY ETF.
[394]
You may choose to do this when you do not have 100 shares in your stocks portfolio,
[400]
but you would still like to hedge against potential bearish momentum by
[405]
buying a put option on an ETF that has a strong correlation to your stocks portfolio.
[412]
The second reason is to buy a put option as an alternative way to shorting a stock.
[418]
But this reason of buying a put option would be
[421]
more applicable for the traders than for investors.
[425]
This is because traders may be speculating on the price decline to profit from it.
[430]
But as investors, we are generally looking to profit from price increases
[435]
in the stock markets.
[436]
The advantage of buying a put option over shorting a stock directly
[441]
is that the absolute amount of losses is capped at the put premium amount paid.
[447]
Whereas if you short a stock directly,
[449]
the losses can be unlimited depending on how high the stock prices increase to.
[456]
So that’s the end of my sharing on put options and I hope that you now
[461]
have a better understanding of what put options are and how they work!
Most Recent Videos:
You can go back to the homepage right here: Homepage