Now let's imagine that you have a strong feeling a particular stock is about to move lower.

Before puts came into existence, your only alternative was to short sell the stock. Short selling stock is an incredibly risky strategy. Should the stock move higher, your loss would be theoretically unlimited. Rather than opening yourself to enormous risk, you could buy puts (the right to sell the stock at a fixed price).

Example

Let's look at an example option. Cisco (CSCO) is trading at $16.07. The JUN 15 puts are trading for $0.55. For $55 you could buy one JUN 15 put (100 shares x $0.55). Since each contract controls 100 shares, you now have the right to sell 100 shares at $15 per share. If the stock stays at or above $15.00 before the option expires, the most you could lose is your initial investment of $55.

On the other hand, if the stock falls to $11 at expiration, the JUN 15 put will be worth $4 (strike price: $15 – current stock price: $11). At this point, your put is worth $400 ($4 x 100 shares). After subtracting the cost of the premium paid and before commissions your gain is $345, a 627% gain on your investment.

To achieve the same percentage gain on a typical stock trade, a $100 stock would have to increase in value to nearly $800 per share. Needless to say, that doesn't happen every day.

To better see the leverage of options, let's look again at the returns on a percentage basis.

Now, let's see what happens if the stock unexpectedly rises.

If you sold the stock short at $15, thinking it would go down, and it rose quickly to $20, you can buy the stock and limit your losses. In this case, you would lose $500 (100 shares x $5 share). It's also easy to see that this could get worse. The stock could continue climbing indefinitely. Had you purchased the puts rather than sold the stock short, your loss would be limited to the price of the puts-in this case $55.

Risks

With both puts and calls, the risks fall into the same categories, time and market direction.

To make a profit, the buyer of these options has to be right about the price movement of the stock and the time frame in which it will occur. If the stock doesn't make its move before the options expire, they will expire worthless. While a stockholder is concerned with market direction, the timeframe isn't as critical because stock doesn't have an expiration date. You can hold a stock for decades. You can't do the same with options. With the exception of LEAPS (long-term option contracts), most options expire in a matter of months.