1) First, let's examine how a speculator can use a put:
Take Google, which recently had news that the government would look into its anti-trust behavior. The stock is currently at $475 (rounded slightly). You believe that the price of Google (GOOG) will decline between now an August. One strategy is to short the stock; but that incurs the cost of borrowing the stock. In addition, potential margin calls and unlimited go along with shorting equity.
Herein come options:
Say you believe the stock will fall to $450. The $475 (The At The Money) put option is currently trading for $20.50. If you are indeed correct, then you will make $4.50 per stock ($450) total. The break-even point of a speculation put for this option is the strike ($475) minus the cost ($20.50):
475-20.50=$454.50.
If the stock drops below $454.50, then money will be made. If the stock is indeed $450 in August, you will buy the stock at cost ($450) then exercise your put. This put gives you the right to sell the stock you bought at $475, a $25 per share gross profit. Subtract the $20.50 you paid for the shares, and you have a $4.50/share profit.
If you are wrong, and the stock shoots to $550, you can only lose the $20.50/share ($2,050) you bought the option for.
Shorting equity would equate to $75/share ($7,500). A "stop order" can be placed if the stock raises (say, above $500). This will limit the loss from being wrong. However, if the stock rises above $500 before dropping to $450, a short position would lose money, where the put would profit.
2) Let's now assume you own Google. You are long Google, believe in the company, but are worried about the downside of this potential lawsuit. In that case, you can buy a put to protect your investment. You can hedge your position as follows:
Let us say that you buy a $475 (the current stock price) put. If the stock goes up to $550, you make money (profit $75/share), as you own the stock, but the put expires worthless. You lose $20.50/share on the put, for a net profit of $49.50/share.
Now: Assume the stock goes to $450. You can use your put to sell the stock at $475, curbing the potential loss from the stock's drop. Instead of losing $25/share, you only lose $20.50/share.
Here are the three strategies compared side by side. Notice that a hedge put makes money by the stock increasing in value, where a speculating put earns money by a drop in the price. The traditional long will out perform the hedge put, but has a larger downside risk.
