This article is from the Investing Articles: Stocks and Options series.
If an investor owns the underlying security and buys a put option, he has created a position where he has limited downside risk in the underlying security until the option expires. This is a fairly common options strategy using the put option as insurance.
An example of this options strategy is the following. Assume an investor owns 100 shares of XYZ and the current price is 93. Further assume that the November 90 put is trading for 2. Until November expiration, the investor's maximum possible loss on the XYZ stock is 5 points. That is the 3 points XYZ is out of the money and the 2 points paid for the option. If the price of XYZ rises, the investor profits on the rise in price of the stock less the 2 points paid for the put option. Should XYZ decline in price below 90 at expiration, the investor could sell the underlying stock for 90, or he could liquidate the put option and pocket the amount at which the put option liquidated.
The investor who own stock and buys a put option for each 100 shares owned is not looking for a profit on the option. He is looking to protect his investment. It's a sort of insurance policy against a large short term decline in the underlying security. Alternatively, an investor who has just assumed a position in a stock may want to buy a put option to protect him in case he guessed wrong on the direction of the stock.
Buying an in-the-money put option will provide the most protection to the investor should the stock decline. Buying a slightly out-of-the-money put option will provide less protection, as shown above. And a deep out-the-money put option functions as a disaster policy. It won't provide much insurance for a small decline in the stock but will provide insurance in the case of a major disaster. I find that the best strategy is the slightly out-of-the-money put option. It offers good risk to reward ratio.