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I would like to verify that I have a correct understanding of hedging using a put option contract.

For stock XYZ, the current price is $12.50. When I look at the options trading table, it appears that I have the option to purchase a put option with the strike price of $12 for $0.59. This makes sense, as from my understanding, I can sell 100 shares of this stock for $12, even if the shares dip below $10 by paying the $0.59 premium.

What I dont understand is why I also have the option to buy the put option contract for a strike price of $13 (higher than the current stock price). The ask price for this contact is 1.16, significantly higher than the $12 strike price option.

Why is this?

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Options, both puts and calls, are typically written/sold at different strike prices. For example, even though the stock of XYZ is currently trading at $12.50, there could be put options for prices ranging from $0.50 to $30.00, just as an example. There are several factors that go into determining the strike prices at which people are willing to write options.

  • The price history of the stock = Options are written at various points in a stock's lifetime. In this particular case, the $13 strike option you are referring to may have been written when the stock was trading above $13 per share. Or the writer of the option may be very bullish on the stock and thinks that writing the put option at a price higher than the current price (and receiving a larger premium) is worth the risk.
  • The time to expiration = The longer the time to expiration, the more opportunity for a stock price to fluctuate by a greater magnitude. Since a put writer is bullish on a stock, the longer the time to expiration, the longer a stock has to rise. So again, by writing the option at a strike above the current trading price the writer can earn a larger premium.
  • The future expected price movement of the stock = Since the put writer is betting that the stock price will go up, their assumption is that the price will rise above the strike price and the option will never be exercised. The more bullish they are, the higher the strike price they are willing to write so they can collect the largest premium.

The writer/seller of an option is the person on the other side of the trade that has the opposite opinion of you. If you are interested in purchasing a put on a stock to hedge your downside, that means the writer/seller of the put is betting that you are wrong and that the stock price will rise instead.

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