The easiest way to think of options is to think of a car insurance policy. The insurance gives you coverage for a specified period of time so if anything happens to your car then you are your insurance company pays for the repairs or the write-offs. In other words, the insurance company takes the financial risk from you in exchange for a small fee called premium.
Insurance companies have sophisticated algorithms calculating the risk of your car needing repairs or write-off based on countless attributes, such as the age of your car, the driver's driving history, location, etc. Their objective is obviously to ensure that they will always retain more money in their pockets than the amount of pay-outs they have to make.
The stock options are very similar. Each option has an expiration date, a value (premium) and a strike price, which is like the market value of your car.
For example, let's say Joe bought 100 shares of a company called XYZ for $100 a share. The price goes to $120 and Joe doesn't want to lose the profit he made so far so he wants an insurance against a potential price fall. In this instance Joe can purchase put options to protect his position.
Insurance against stock price fall
Assuming that it's currently January and Joe wants to protect his profit for the next 6 months. He goes ahead and purchases a put option with June expiration and at the $120 strike price. He understands that he has to pay $400 ($4 x 100 as each option covers 100 shares) premium for this insurance but he's happy with that as it's only a fraction of the $2,000 profit that he already made on this investment (his initial investment was 100 shares at $100 = $10,000 and it is now worth $12,000).
So what does this look like from Joe's profit's perspective?
a. Fortunately for Joe, his investment decision started to pay off immediately after his purchase as the stock price just kept going up.
b. The stock price reaches pretty high levels making the value of Joe's investment skyrocket.
c. When he saw that the stock price started to come back down, he sacrificed a portion of his (paper) profit and bought a put option (see how his profit dropped immediately).
d. Even though the stock price fell sharply and went below his initial purchase price, his investment was still profitable. While the stock price was below $120 his profit was kept at $1,600 (he spent $400 on the insurance premium).
e. When the share price bounced back up and reached new highs then his profits increased once again, but this time his profit calculations had to factor in the $400 that he spent on the premium. In other words, when the stock price hit $130 then his profit was $13,000-$10,000-$400=$12,600.
So what does this look like from Joe's option price perspective?
This question might confuse some readers so let me clarify: during tough times (point d. above) Joe's paper profit remained positive not because the share price did not move for him but because the value of the put option that he purchased went up.
Important to note that his investment into the insurance (option purchase) started to generate him profit when the share price went below $116. That's because the strike price of his insurance is $120 and he paid $4 premium.
Long put option p/l chart
So what does this look like from the option seller's perspective?
It's exactly the opposite. The option seller receives $400 credit but as soon as the stock price goes below $116 then the option seller starts to rapidly lose money.
Short put option p/l chart
Let's take a look at the option seller's position on our original graph. As we can see the share price starting to drop rapidly (a.) and reaches a pretty low level (b.). At this point the option seller is heavily at a loss while the option buyer (Joe) is protected.
Once the share price increases goes back above $120, both the option seller and the option buyer are happy as they both make money.