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Friday September 05, 2008 |
Basic
Strategies for Options - Buying Puts
Buying
a put option gives the holder the right, but not the obligation to
sell a specified underlying security at a specified price for a
fixed period of time. There
are two very good reasons why an investor would choose to buy a
put option.
Participate
in an Anticipated Decline
The
right to sell a security at a fixed price can be a very valuable
right if the underlying stock price is declining. Remember, one of the principle benefits of options is
leverage, by fixing the price at which to sell the underlying
security the option buyer gains tremendous leverage.
In
many cases astute investors will use puts to establish short
positions in a particular security instead of short selling the
common stock. This practice makes sense for two reasons. First, when a put is purchased the potential loss is
limited to the premium paid. By contrast the short seller of common stock is subject to
potentially unlimited losses should the stock rally. Second, the put buyer will never be required to close the
position prematurely, the right to sell the underlying common
stock at a specified price lasts for the life of the contract. By contrast, short selling common stock requires the seller
to borrow stock. This
borrowed stock may be called back by the owner at any time
resulting in the potentially premature closure of the position.
Let's
return to our example featuring IBM. We will assume that IBM is trading at $100 and the IBM
November 100 put is trading for a premium of $2. If an investor is bearish for IBM he may decide to buy this
at-the-money put option. His
out of pocket cost is $200 but he now controls 100 shares of IBM
for a fixed period of time.
If
our investor is correct about the direction of the common stock
price and during the life of his option contract IBM declines to
$95. The right to
sell IBM common stock at $100 is suddenly more valuable, the IBM
November 100 put moves from being at-the-money to being in-the-money, the option price increases to $5. Our investor can now do one of two things to realize his
profit. He can:
1. Buy 100 shares of IBM stock at $95 per share in the open
market for a capital outlay of $9, 500 and simultaneously exercise
his put option to sell 100 shares of IBM at $100 per share for
proceeds of 10,000. If we subtract the cost of the put option ($200) the investor
earns a profit of $300.
2. Sell the IBM November 100 put in the open market. The option is in-the-money and should command at least $5
per contract or $500. If
we subtract the initial cost of put contract ($200) our investor
earns a profit of $300, 150 percent return on his initial modest
investment.
As
you can see, it makes little sense for our investor to exercise
his right to sell the common stock at $100 unless he wishes to
hold a short position in IBM common stock after the expiration. Exercising the option would incur a commission cost
and put
his modest profit at risk.
If
our investor is incorrect about the direction of IBM common stock
his option is likely to decline to zero resulting in a 100 percent
loss of investment.
Hedge
a New Long Stock Position, the Married Put
Under
certain circumstances an investor may want to own a particular
stock but he is uncomfortable with the risk of holding that
security. Huh? Let's say the common stock has fallen substantially
after an earnings disappointment. Our investor thinks the worst is over but he is still a
little uncomfortable with the possibility of further weakness.
The
investor can limit the risk of stock ownership by simultaneously
buying a put on the stock; a hedging strategy commonly referred to
as a "married put." This strategy establishes a minimum
selling price for the common stock during the life of the option
contract, limiting potential losses to the cost of the put plus
the difference, if any, between the purchase price of the stock
and the strike price of the put. Consider this example.
IBM
common stock fell $15 to $90 because the firm has just warned that
future profits may be less than expected due to slower sales in
Europe. Our investor
believes the selling is overdone and this is perfect a opportunity
to establish a long position in IBM common stock but he is wary
of further bad news and possible price weakness. He decides to employ the married put strategy to limit
downside risk. He
buys 100 shares of IBM at $90 for a cash outlay of $9,000 and
simultaneously buys one November 90 put for a premium of $3 per
contract or $300. By
purchasing this put option he has ensured that the lowest price he
will receive for his long stock position for the life of his
option contract is $90 per share or $9,000 yet his potential
profit is unlimited. Let's
run through the possibilities.
1. Our astute investor was correct about IBM common stock and
after the initial reaction IBM shares rally to $105. Our investor is feeling pretty good about his strategy and
himself, he decides it is time to collapse the strategy and take
his profit of $1,200 (proceeds from the sales of IBM common stock
at $105 per share ($10,500) less his initial cost for the stock
$9,000 less the cost of the IBM November 90 puts ($300))
2. Our investor was dead wrong about the price of IBM common
stock. After a few
days more bad news hits and IBM shares fall precipitously again,
loosing a further $10 to $80 per share. Our investor is not happy about the turn of events but he
is very happy he decided to use the married put strategy. With IBM common stock trading at $80 per share he has an
unrealized loss of $10 per share or $1,000 from his initial purchase price
of $90. Our investor
exercises his IBM November 90 puts and sells 100 shares at $90 to
break-even on the long stock position. His loss for the entire strategy is limited to the initial
cost of the IBM November 90 puts, the premium of $3 per contract
or $300.
The
married put strategy is a particularly good way to limit the risk
of holding volatile stock positions. Potential losses are limited to the cost of the put premium
plus the difference, if any, between the put strike price and the
price of the common stock yet potential profits are unlimited.
Hedge
an Existing Long Stock Position, the Protective Put
One
of the more common strategies involving the purchase of put
contracts is the hedging of profitable long stock positions,
commonly referred to as the "protective put". Like the married put, the protective put hedges a long
stock position from potential price weakness but there is one
important difference, protective puts are used to protect
unrealized gains. By buying a put the investor ensures a specific selling price.
Some
might question the utility of this strategy; after all, if an
investor is really worried about downside risk they could simply
sell the stock. That
is true but there are specific instances where the use protective
puts can really help the careful investor. Consider this example.
Our
investor has had the good vision to buy 100 shares of Yahoo! (YHOO)
when the stock was floundering near $140 per share. His initial outlay was $14,000. After several months of near exponential gains the stock
has rallied to $210. Our
investor has an unrealized gain of $70 per share or $7,000. In two weeks Yahoo!
is scheduled to release earnings.
It is widely anticipated that the earnings will meet or
exceed Wall Street consensus earnings estimates but a negative
report could quickly erase all of the gains earned during the past
several months. Our
investor considers the possibilities and decides Yahoo! is a stock
he would like to hold for the long term but the upcoming earnings
report could have a negative impact on the stock price? He is not willing to risk surrendering his unrealized gains
so he decides to buy some insurance against possible losses. With Yahoo!
trading at $210 he buys the Yahoo! November 210
put for a premium of $7 per contract or $700. For just $700 he has ensured that the worst possible price
he will receive for his Yahoo! Stock is $210 during the life of
his option contract. The
$700 premium is the maxium loss for this strategy. Now let's run through the possibilities.
1. The earnings report for Yahoo! comes and our investors'
worst fears are realized, the common stock begins to fall
immediately. In short
order the common stock falls to a price of $140 per share. On paper the investor has now surrendered all of his
unrealized gains but he remembers that he had the foresight to
protect his long stock position with the Yahoo! November 210 puts. He now has two options, he can exercise his right to sell
Yahoo! common stock at $210 and still earn a profit of $6,300
(proceeds from exercising his option to sell 100 shares of Yahoo!
at $210 ($21,000) less his initial cost for the common stock
position ($14,000) less the cost of the Yahoo! November 210 puts
($700)) or he can sell his Yahoo! November 210 puts in the open
market. Because this
option is now deep in the money it should command a value of at
least $70 per contract, or $7,000 leading to a profit of $6,300
(proceeds from the sale of the Yahoo! November 210 puts ($7,000)
less the initial cost of this position ($700). Buy selling this option our investor offsets the loss in
the Yahoo! common stock.
2. The earnings report for Yahoo!
comes and the firm manages to
beat Wall Street expectations and announces a three-for-one stock
split. Yahoo! common
stock surges a further $60 to $300 per share. Our investor is relieved that he did not sell his stock
ahead of the earnings, he maintains his position and his at the
money Yahoo! November 210 puts suddenly become out-of-the money
puts. In short order
they decline to zero because their utility as insurance is no
longer valid – after all, the right to sell Yahoo! common stock
at $210 per share is not worth anything when the common stock is
selling at $300. Our investor dismisses the $700 loss for the puts as the cost
of piece of mind and takes comfort in the surging Yahoo! common
stock price.
Like
the married put, the protective put strategy is a very good way to
limit the risk of holding a very volatile stock. Potential losses
are limited to the cost of the put premium plus the difference, if
any, between the put strike price and the price of the common
stock yet potential profits are unlimited.
selling puts
selling calls
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Bearish Strategies > Buying
Puts
