Let's take the example of a person who owns 10,000 shares of a large hotel company when the shares trade at $10 each. This person believes the threat of a recession poses a risk to the company's profit, and its share price, over the next year. Rather than sell her shares, the investor may prefer to buy a put option - or the right to sell her 10,000 shares at a price of $8 at any time over the next year. While the option will cost money to purchase, it will provide protection to the investor. If the shares tumble to $5, as the person feared, she won't face the full loss. Instead, she can exercise the put option and sell the shares for $8 to the person or institution who wrote, (or "sold" in industry parlance), the put option.
Using Call Options
Take another case of an investor who believes that one of two companies that are bidding for a big government contract will prevail, and who buys shares of that company. Rather than lose out if the other company wins the contract, he purchases a call option on shares of the second company.
To illustrate this strategy in action, assume the second company (which we'll call Company B) has shares that trade for $10 today. The investor might purchase a call option for the right to buy 1,000 shares of Company B stock at $12. (The cost of the option is called a premium.) If Company B wins the contract and its shares jump to $15, the investor can exercise the call option and buy the shares at a $3 discount, and then sell them immediately for a profit. If Company A wins, as he expected, and Company B shares stay at $12, the option expires worthless.
