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March 9, 2006

“Putting” Things Into Perspective

By Mike Parnos,

In our previous two columns we examined the “call” option – one of the two types of options. Today we’re going to explore its evil twin – the “put” option. Actually, it’s not really evil, but those new to options often have a hard time grasping the concept. Once you understand how puts work, you will appreciate and embrace the flexibility they can provide. To know them is to love them. 

Put options were originally created for hedging purposes – to protect an existing asset. However, as a tribute to its flexibility, the put option has become even more popular as a speculative directional downside bet to the world of option gamblers. 

Buying a “put” option, as in a call, gives you a right, but not an obligation. However, in the case of the “put”, you are buying the right to SELL your asset at a predetermined price on or before a predetermined time. Remember, owning a “call” option gives us the right to BUY an asset. 

A Speculative Scenario. 

1. It’s March 10th. 

2. For whatever reason, you believe that XYZ shares, currently trading at $76, are going to trade down significantly in the near future. At this time, you do NOT own any shares of XYZ stock. 

3. You can buy an April $75 put option on XYZ stock that expires in 6 weeks. That means, you have bought the right (but not the obligation) to sell 100 shares to the market at $75 per share for the next six weeks at a cost of $2.75/share (or $275/contract). What you are hoping for is that XYZ will be down at $60.00.

The tough part for people to grasp is that you don’t have to own the shares of stock in order to buy the right to sell shares. You are buying rights and selling rights – not the stock. The ownership of the actual asset is not necessary. Most people who speculatively buy options, are trying to take advantage of the leverage provided by options. They have no interest in actually owning shares and then selling them. Speculating with a put option means you are placing a bet (just like Las Vegas) that the asset will go down. 

It’s much simpler to buy an option and later sell that option back to the marketplace for a profit. There will always be a place where you can sell any option you purchase. The option market makers HAVE TO create a market for the option you have purchased. There will always be a bid and an ask price for the XYZ $75 put option. So, if you want to close out your position, you can. However, the price of the option will fluctuate higher or lower depending on the movement of the underlying asset – in our case, XYZ stock. 

If you are lucky enough to guess right, and XYZ trades down, you will see that the April $75 put option you bought for $2.75 will start to increase in value. Remember, when you own an option, you do not have to wait until just before expiration to sell your option and take your profits. You can, at anytime prior to expiration, sell your option.  

For instance, if XYZ moves down to $68 in two weeks, your $75 put option will have a minimum market value of $7.00. You paid $2.75 for the option. If you sold now, you would have a profit of at least $4.25 ($7.00 -
$2.75). That’s an impressive percentage gain – and you didn’t have to screw around buying and selling stocks that requiring chunks of cash or marginable securities in your account. 

A Hedging Scenario. 

1. It is March 10th. 

2. You own 1,000 shares of DELL (Dell Computer) with a cost basis of $35.75. 

3. Dell is about to come out with an earnings announcement in the next 30 days. You are afraid that Dell will have a bad earnings report, but you don’t want to sell your stock. 

4. You can buy an April $35 put for $1.50 per share ($1,500 for 10 contracts). 


This is commonly known as a “protective” put. Why? Because you just purchased the right to sell your 1,000 shares back to the market for $35/share. It doesn’t matter how DELL reacts to the earnings announcement. You are protected. Even if DELL goes down to $20/share, you still have the right to sell your stock to the marketplace at $35. 

This is also known as an “insurance” put, because you are insuring your investment against a catastrophic loss. In this day and age, almost daily we hear about CEO’s who have their hand in the till, companies getting caught cooking the books by manipulating earnings reports. Go ahead, pick a scandal. It’s going on somewhere. Where there is big money, there are thieves – and we only hear about the ones that get caught. They may be wearing three-piece suits, but a thief is a thief. 

Owning stock is dangerous!! You are exposed for the entire amount of your investment. Using “protective” or “insurance” puts is the only intelligent way to own a stock. You insure your home, your car, your health, etc. – why wouldn’t you insure your investments? Sure, there is a cost for insurance, but all it takes is one catastrophic event and a huge chunk of your investment can easily disappear. 

Notice, in our DELL example, DELL is trading at $35.75. When we buy the $35 put, we are protected from $35 all the way down to zero. That leaves $.75 unprotected. Well, most insurance policies have a deductible. When you decide to buy the $35 put as protection, you are accepting a $.75 deductible – just as you would have a $500 deductible on your car or homeowner’s insurance policies. Deductibles will vary depending on where or when you would like your insurance to kick in. 

Calculating The Results (on 10 contracts) 

1. The original investment (cost basis) for DELL is $35,750. 

2. The cost of buying the DELL April $35 put is $1,500 

3. DELL has very bad news and falls to $20/share. New value of DELL is $20,000. 

4. The value of the DELL April $35 put is now at least $15,000. 

5. Sell the $35 put back to the market for $15,000. 

6. Sell the 1,000 shares of DELL @ $20 for $20,000. 

7. You now have $35,000. ($20,000 + $15,000) 

8. Subtract the original cost of the “insurance” put: $1,500 

9. You have $33,500 – which is a hell of a lot better than just 1,000 shares of DELL worth only $20/share ($20,000). 

Don’t Want To Sell The Shares?

What if you don’t want to sell your shares? There are a variety of reasons people may not want to sell their shares of stock. The most common is that they have owned the stock for a very long time and their cost basis for the stock (as a result of stock splits, etc.) may be only $5.00/share. If they sold their stock, there would be substantial capital gains tax ramifications. What people typically do is just sell their protective put, pocket the money, and hold onto the shares. 

Mike Parnos – A Little Knowledge Goes A Long Way 

Who is he? Mike Parnos is a guy who has “been there and done that” – and done it often! Known as the “Options Therapist,” Mike has been trading, consulting, managing money and teaching option strategies for over 12 years. Both individually, and through his writings, Mike specializes in teaching, and using, conservative non-directional option strategies while providing therapeutic guidance to thousands of individuals, brokers and institutional traders. Over the years, he has learned from his mistakes, and the mistakes of others. He’s here to share his wisdom with you. “Trading is as much psychological as it is skill,” says Mike. “Keep an open mind. You never know what might find its way in there.”

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Disclaimer
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

ISSUE | March 9, 2006