Let's say that you don't
like company ABCD that's right now trading
for $50 a share. But you don't have the
stomach to short the stock because there's a
possibility that you could lose an infinite amount
of money if you short it. You still have an option. Quite literally, you
still have an option. You can buy a put option. Once again, we're dealing
with the American variation. And just like an
American call option, an American put option
gives you the right to exercise the option any time
before the expiration date. A European call
or put option, you can only exercise on
the expiration date. And the situation with a
put option, a call option gave you the right to buy the
stock at a specified price. A put option is the opposite. It gives you the right to sell
the stock at a specified price. So this little
made up put option I've constructed right here. It's maybe being sold on an
exchange for $5 per option. And it gives you the
right to sell company ABCD at $40 a share any
time over the next month. And let's see how, if you were
to buy this, how this really is a bet that the
company would go down. So let's imagine the scenario
where the company does what you expect, it goes down. And one month later, it
just keeps going down. You're like, well, I
better use it today because it's going to expire
if I don't use it today. So you exercise the
option right over there. And so what this allows you to
do is sell the stock at $40. And if you don't
own it, that's OK because you could go and buy the
stock right now on the market. You knew it was
going to get cheaper. So you can buy it for $20,
and then exercise your option and sell it for $40. So you're buying at $20 and
immediately selling for $40. So you're going
to be making $20. And then if you
subtract out the price that you had to
pay for the option, you're going to
have a $15 profit. You're going to have a
$15 profit over here. Let me scroll over to the
right so you have some space. And this is, of course, the
situation with the put option. This is the put option. And if your bet goes against you
and the stock actually goes up, it's not going to be
like a short position where you can lose an
unlimited amount of money. In that situation,
let's say the stock just keeps going up and
up and up and up. Well at any point
above $40, you're like, there's no point in me
exercising the option. So you just let it expire. So in that situation, you
just wasted your money buying the actual option. So you just lose the actual $5. Even if that stock were to
go up to a gazillion dollars, you're not required to
buy it back like you would if you were shorting it. You can just let
the option expire.