Let’s say that you currently own 1,000 Telstra shares, which are trading at $4. However due to recent share price volatility, you decide to take out an insurance policy, or buy a put option, against a share price fall. You buy 1 Telstra September $4 put option, for 50 cents, for a total cost of $500 (one option contract covers 1,000 shares). Now with the put option in hand you can breath easier since it grants you the right – but not the obligation – to sell your Telstra shares for $4 anytime before the expiry date in September.
Now let’s say that your concerns are realised and the shares hit $3. You could exercise the option and sell your Telstra shares for $4. Taking into account the cost of the option, the net sale price is $3.50. Alternatively, you could sell your put option and retain your shares.
In the event that Telstra shares had scooted higher over the period – above $4 and beyond – your option will expire worthless and you’ll be out of pocket by $500. However, remember that your shares have also increased in value over this period.