Sunday, March 11, 2007

What's A Put Option and How Can It Help?

In recent weeks, I've devoted some space to basic information about calls. I've written a little about buying calls when a trader thinks a stock is going up and I've written about selling calls against stock the trader already owns (writing covered calls) and I've discussed risks of entering those types of trades. While calls may be used in a number of additional ways, I've tried to give the reader a beginning understanding of some of the uses and risks of certain strategies using calls.

This week, I'm going to turn my attention to the definition of put contracts and one important use that can be made of puts from the put buyers' perspective. If you're new to the Newsletter, you may want to check the archives for the June 24th Newsletter "A Little About Call Options" where I covered terminology such as expiration, contract size, strike price, etc.

Remember that options are simply contracts between a buyer and a seller. When an option contract is opened the buyer always obtains a right and the seller undertakes an obligation. In the case of a call, the buyer obtains the right, but does not have the obligation, to buy the stock anytime before expiration (in the case of American style options) at the strike price and in exchange for that right, pays the seller a premium. The seller of a call, on the other hand, receives a premium and for that payment undertakes the obligation to deliver the stock, if called (known as being assigned), at the strike price anytime before expiration.

Now, let's see what right the buyer of a put obtains and what obligation the seller takes on in exchange for the premium. The buyer of a put obtains the right, but does not have the obligation, to put his stock to the seller at the strike price anytime before expiration and for that right, pays a premium. Think about that for a moment. The buyer of a put can force someone to buy his stock at the strike price anytime before expiration. Suppose Mrs. Trader owns 500 shares of ABC at $50 a share. If the company went down the tubes, the stock could literally go to zero, couldn't it? Mrs. Trader would lose $25,000 if that happened, wouldn't she? Now suppose it is July and that Mrs. Trader owned the same 500 shares of ABC stock at $50 a share. Also suppose she also bought 5 contracts of the Dec 50 puts on ABC for $5. Remember, most option contracts control 100 shares of stock (always check) so she would have spent $2500 to buy those puts (100 shares x 5 contracts x $5.00 a share). Now what would her situation be if the stock went to zero sometime before the Dec expiration? Well, she could exercise her $50 puts and require someone (she wouldn't know who) who sold $50 puts to buy her now worthless stock for $50 a share. She would "put it to him." Now, she would sell her stock for $25,000 and would only have lost her $5 premium ($2,500). That strategy is what is known as "buying a protective put."

Protective puts have been likened to insurance policies. Just like when buying insurance, the buyer of a put pays a premium. The premium buys the protection of being able to force someone to buy the stock at whatever strike price the buyer has chosen. In our example with Mrs. Trader, she bought the at the money put so anytime until expiration, she could force someone to buy her stock for what she paid for it. If she decided to do that, her loss would be limited to what she paid for the put. Of course, Mrs. Trader could also have chosen to buy an out of the money put which would have cost less. Suppose she chose to buy the Dec 45 put instead of the Dec 50 put because it only cost $3.00 a share instead of the $5 for the Dec 50. Now, she would pay $1,500 (100 shares x 5 contracts x $3). Though she is paying less for the puts, she is also adding some risk. Instead of forcing someone to pay $50 a share if she exercised her puts, she could only force them to pay $45 a share. In effect, she is taking on an additional $5 a share risk herself. That additional $5 risk is akin to the deductible in an insurance policy.

While you can probably see the reduced risk during the life of a protective put, it is also necessary to be aware that buying protective puts also increases the total cost of the position. When buying a stock and a protective put, the cost is obviously greater than buying the stock alone, but the risk of stock ownership is decreased during the life of the put option. When we buy a house or a car we insure it against loss (many times with a deductible). As long as the insurance policy is in effect, we reduce our risk of loss if something happens to the house or to the car, but, of course, we pay for that protection. Buying a protective put is analagous.

Though a trader or investor can make a lot of money buying stock, stock buying is always risky. Each trader as part of his or her business plan should decide whether and under what circumstances protective puts should be utilized. If someone considers themselves to be a "long-term investor" who doesn't want to babysit their positions, it might be wise to consider protective puts. How about the investor who has all his eggs in one basket, like the stock of the company where they work. Should they consider some protective puts? Think of all the people who lost fortunes with Enron or Worldcom. I'll bet they wish they knew about protective puts.

As you have probably gathered by now, the seller of a put is paid the premium and, for that payment, undertakes the obligation to buy the stock at the strike price if it is assigned to him at anytime before expiration. In a sense, the seller of a put is akin to the insurance company since the seller is taking on the risk in exchange for the premium received.

While a complete exploration of put strategies is well beyond the scope of this article, I do want to note that as the price of a stock goes down, the price of a put generally goes up. Often traders won't assign their stock when it goes down, they will simply sell their current puts for a profit and then, perhaps buy more. Puts also may be used to profit when stock is dropping, but that is the subject of a future article.

Bill Kraft, Editor
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1 comment:

Justin L. Brown said...

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