Good Trend But Not Enough: You bought a LEAPS put for 5 with a striking price of 30, when the stock was at $32 per share. There were 22 months to go until expiration and the entire put premium was time value; you estimated that there was plenty of time for the price of the stock to fall, producing a profit. Between purchase date and expiration, the underlying stock falls to 27, which is 3 points in the money. At expiration, the put is worth 3, meaning you lose $200 upon sale of the put. Time value has evaporated. Even though you are 3 points in the money, it is not enough to match or beat your investment of $500.

The farther out of the money, the cheaper the premium for the option—and the lower the potential to ever realize a profit. Even using LEAPS and depending on longer time spans, you have to accept the reality: The current time value premium reflects the time until expiration, so you will pay more time value premium for longer-term puts. That means you have to overcome more points to replace time value with intrinsic value.

FIGURE 4.1 Diminishing time value of the put relative to the underlying stock.

If you buy an in-the-money put and the underlying stock increases in value, you lose one point for each dollar of increase in the stock’s market value—as long as it remains in the money—and for each dollar lost in the stock’s market value, your put gains a point in premium value. Once the stock’s market value rises above striking price, there remains no intrinsic value; your put is out of the money and the premium value becomes less responsive to price movement in the underlying stock. While all of this is going on, time value is evaporating as well.

Smart Investor Tip

For option buyers, profits are realized primarily when the option is in the money. Out-of-the-money options are poor candidates for appreciation, because time value rarely increases.

Whether you prefer lower-premium, out-of-the-money puts or higher-premium in-the-money puts, always be keenly aware of the point gap between the stock’s current market value and striking price of the put. The further out of the money, the less likely it is that your put will produce a profit.

FIGURE 4.2 Deep-in/deep-out stock prices for puts.

To minimize your exposure to risk, limit your speculation to options on stocks whose market value is within five points of the striking price. In other words, if you buy out-of-the-money puts, avoid those that are deep out of the money. What might seem like a relatively small price gap can become quite large when you consider that all of the out-of-the-money premium is time value, and that no intrinsic value can be accumulated until your put goes in the money. Added to this problem is the time factor. As shown in Figure 4.2, you may want to avoid speculating in puts that are either deep in the money or deep out of the money. Deep-in-the-money puts are going to be expensive—one point for each dollar below striking price, plus time value—and deep-out-of-the-money puts are too far from striking price to have any realistic chances for producing profits.

Put Buying Strategies

There are three reasons to buy puts. The first is purely speculative: the hope of realizing a profit in a short period of time, with relatively small risk exposure. This leveraged approach is appealing but contains higher risks along with the potential for short-term profits. The second reason to buy puts is as an alternative to short selling of stock. And third, you may buy puts to provide yourself with a form of insurance against price declines in a stock long position.

Strategy 1: Gaining Leverage

There is value in the leverage gained using the put. With a limited amount of capital, the potential for profits is greater for put buyers than through stock short selling, and with considerably less risk.

Example

Safer than Shorting Stock: A stock currently is valued at $60 per share. If you sell short 100 shares and the stock drops five points, you can close the position and take a profit of $500. However, rather than selling short, you could buy 12 puts at 5, for a total investment of $6,000. A five-point drop in this case would produce a profit of $6,000, a 100 percent gain (assuming no change in time value). So by investing the same amount in puts, you could earn a 100 percent profit, compared to an 8.3 percent profit through short selling.

This example demonstrates the value in leverage, but the risk element for each strategy is not comparable. The short seller faces risks not experienced by the put buyer and has to put up collateral and pay interest; in comparison, the put buyer has to fight against time. Risking $6,000 by buying puts is highly speculative and, while short selling is risky as well, the two strategies have vastly different attributes. The greater profit potential through leverage in buying puts is accompanied by equally higher risk of loss. However, even without a large sum of capital to speculate with, you can still use leverage to your advantage. This comparative analysis shows the flaw in analyzing two dissimilar strategies. Because the risk attributes are so different for each, it is not accurate to draw conclusions based only on potential returns.

Example

Comparing Apples to Oranges: You buy a LEAPS put for 5 with a striking price of 60 and 18 months until expiration. The stock currently is selling at $60 per share; your option is at the money. Aware of the potential profit or loss in your strategy, your decision to buy puts was preferable over selling short the stock. The luxury of 18 months in the LEAPS put is preferable over remaining exposed to short selling of stock. As shown in Figure 4.3, a drop of five points in the stock’s market value would produce a $500 gain with either strategy (assuming no change in time value premium).

FIGURE 4.3 Rates of return: selling short versus buying puts.

The short seller, like the put buyer, has a time problem. The short seller has to place collateral on deposit equal to a part of the borrowed stock’s value, and pay interest on the borrowed amount. Thus, the more time the short position is left open, the higher the interest cost—and the more decline in the stock’s value the short seller requires to make a profit. While the put buyer is concerned with diminishing time value, the short seller pays interest, which erodes future profits, if they ever materialize, or which increases losses.

A decline of five points in the preceding example produces an 8.1 percent profit for the short seller and a 100 percent profit for the put buyer. Compare the risks with this yield difference in mind. Short selling risks are unlimited in the sense that a stock’s value could rise indefinitely, creating ever-increasing losses. The put buyer’s risk is limited to the $500 investment. A drop of $1 per share in the stock’s value creates a 1.6 percent profit for the short seller, and a 20 percent profit for the put buyer.

Potential losses can be compared between strategies as one form of risk evaluation. When a short seller’s stock rises in value, the loss could be substantial. It combines market losses with continuing interest expense and tied-up collateral (creating a lost opportunity). The put buyer’s losses can never exceed the premium cost of the put.

Strategy 2: Limiting Risks

It is possible to double your money in a very short period of time by speculating in puts. Leverage increases even a modest investment’s overall potential (and risk). Risks increase through leverage due to the potential for loss. Like all forms of investing or speculating, greater opportunity also means great risk.

Example

Profits Becoming Unlikely: You recently bought a put for 4. However, expiration date is coming up soon and the stock’s market value has risen above striking price. When the put expires, you face the prospect of losing the entire $400 premium. Time has worked against you. Knowing that the stock’s market value might eventually fall below striking price, but not necessarily before expiration, you realize it is unlikely that you will be able to earn a profit.

Risks are lower for puts in comparison to short selling. A short seller in a loss position is required to pay the difference between short-sold price and current market value if the stock has risen in value, not to mention the interest cost. The limited risk of buying puts is a considerable advantage.

Example

Big Problems or Small: You sold short 200 shares of stock with market value of $45 per share; you were required to borrow $9,000 worth of stock, put up a portion as collateral, and pay interest to the brokerage company. The stock later rose to $52 per share and you sold. Your loss on the stock was $1,400 plus interest expense. If you had bought puts instead, the maximum loss would have been limited to the premium paid for the two puts. The fear of further stock price increases that would concern you as a short seller would be a minimal problem for you as a put buyer.

The advantage enjoyed by the put buyer typifies the long position over the short position. Losses are invariably limited in this situation. Although both strategies have the identical goal, risks make the long and short positions much different.

Strategy 3: Hedging a Long Position

Put buying is not always merely speculative. You can also buy one put for every 100 shares of the underlying stock owned, to protect yourself against the risk of falling prices. Just as calls can be used to insure against the risk of rising prices in a short sale position, puts can serve the same purpose, protecting against price declines when you are long in shares of stock. When a put is used in this manner, it is called a married put, since it is tied directly to the underlying stock.

married put

the status of a put used to hedge a long position. Each put owned protects 100 shares of the underlying stock held in the portfolio. If the stock declines in value, the put’s value will increase and offset the loss.

synthetic position

a strategy in which stock and option positions are matched up to protect against unfavorable price movement. When you own stock and also buy a put to protect against downward price movement, it creates a synthetic call. When you are short on stock and buy a call, it creates a synthetic put.

put to seller

action of exercising a put and requiring the seller to purchase 100 shares of stock at the fixed striking price.

This strategy is also one form of a synthetic position. The use of a long put with long stock creates a synthetic call. (When you use a long call to protect your position with short stock, it is called a synthetic put.) The risk of declining market value is a constant concern for every investor. If you buy stock and its value falls, a common reaction is to sell in the fear that the decline will continue. In spite of advice to the contrary, you may have sold low and bought high. It is human nature. It requires a cooler head to calmly wait out a decline and rebound, which could take months, even years. Special tax rules apply to married puts so, in calculating the cost and benefit to this strategy, you also need to evaluate the tax status for your stock. Check Chapter 14 for more tax information on married puts.

The married put is a form of insurance protection. This strategy makes sense, whether you end up selling the appreciated put or exercising it. In the event of a decline in the stock’s value, you have the right to exercise and sell the stock at the striking price. However, if you believe the stock remains a sound investment, it is preferable to offset losses by selling the put at a profit. When you exercise a put, that action is referred to as put to seller.

Example

A Profitable Dilemma: You own 100 shares of stock that you purchased for $57 per share. This stock tends to be volatile, meaning the potential for short-term gain or loss is significant. To protect yourself against possible losses, you buy a put on the underlying stock. It costs 1 and has a striking price of 50. Two months later, the stock’s market value falls to $36 per share and the put is near expiration. The put has a premium value of 14.

In this situation, you have two choices:

1. Sell the put and take the $1,300 profit. Your adjusted cost was $58 per share (purchase price of $5,700 plus $100 for the put). Your net cost per share is $44 ($5,700 less $1,300 profit on the put). Your basis now is eight points above current market value. By selling the put, you have the advantage of continuing to own the stock. If its market value rebounds to a level above $44 per share, you will realize a profit. Without the put, your basis would be 21 points above current market value. Selling the put eliminates a large portion of the loss.

2. Exercise the put and sell the stock for $50 per share. In this alternative, you sell at 8 points below your basis. You lose $100 paid for the put, plus seven points in the stock.

Regardless of the choice taken in these circumstances, you end up with a smaller loss by owning the married put than you would have just owning the stock. The put either cuts the loss by offsetting the stock’s market value decline, or enables you to get rid of the depreciated stock at higher than market value. You have a loss either way, but not as much of a loss as you would have had without buying the put.

The married put in this application provides you with downside protection, which reduces potential profits because you have to pay a premium to buy the insurance. If you intend to own shares of stock for the long term, puts will have to be replaced upon expiration, so that the cost is repetitive. However, as a long-term investor, you are not normally concerned with short-term price change, so the strategy is best employed only when you believe your shares currently are overpriced, given the rate of price change and current market conditions. In this situation, using puts for insurance is speculative but may remain a prudent choice.

downside protection

a strategy involving the purchase of one put for every 100 shares of the underlying stock that you own. This insures you against losses to some degree. For every in-the-money point the stock falls, the put will increase in value by one point. Before exercise, you may sell the put and take a profit, offsetting stock losses, or exercise the put and sell the shares at the striking price.

In the event the stock’s market price rises, your potential losses are frozen at the level of the put’s premium and no more. This occurs because as intrinsic value in the put declines, it is offset by a rise in the stock’s market value. Whether you end up selling the put or exercising, downside protection establishes an acceptable level of loss in the form of insurance, and fixes that loss at the striking price of the put, at least for the duration of the put’s life. This strategy is appropriate even when, as a long-term investor, you expect instability in the market in the short term.

Example

Damage Assessment: You recently bought 100 shares of stock at $60 per share. At the same time, you bought a put with a striking price of 60, paying 3. Your total investment is $6,300. Before making your purchase, you analyzed the potential profit and loss and concluded that your losses would probably not exceed 4.8 percent ($300 paid for the put, divided by $6,300, the total invested). You also concluded that an increase in the stock’s market value of 3 points or less would not represent a profit at all, due to the investment in the put. So profits will not begin to accumulate until the stock’s market value exceeds $63 per share.

A summary of the insurance strategy is shown in Figure 4.4. Note that regardless of the severity of decline in the stock’s market value, the loss can never exceed 4.8 percent of the total amount invested (the cost of the put). That is because for every point of decline in the stock’s market value, the put increases one point in intrinsic value. This status continues until the put expires.

The insurance strategy is also a powerful tool when you plan to sell stock within the next three years, and you are concerned about the potential for losses by that deadline. Insurance protects your value and ensures that, even if the stock’s value declines dramatically, you will not lose by continuing to own the stock.

FIGURE 4.4 Downside protection: buying shares and buying puts.

Example

A Wise Financial Planning Move: Several years ago you invested in 1,000 shares of stock and it has appreciated consistently over the years. You are planning to sell the stock in two years and use the funds as a down payment on a home. You don’t want to sell the stock until it is needed, for several reasons. You will be taxed on profits in the year sold, so you want to defer that until the latest possible moment. In addition, you would prefer to continue earning dividends and, potentially, additional profits in the stock. But you also know the stock’s value could fall. Even a temporary decline would be serious because you will need those funds at a specific date in the future. The solution: Buy 10 puts to insure the value at the striking price. Select puts with expiration dates at or beyond your target date. This reduces your stock’s value by the cost of the puts; but it also ensures that any in-the-money declines in the stock’s price will be offset by gains in the puts’ value.

In this case, the decision to use puts is not merely speculative; it is necessary to insure the stock’s market value. A decline might be reversed within 6 to 12 months, but that could create a hardship if you have a specific date in mind to buy a house. The use of puts as insurance can be applied in many ways to protect capital invested in stocks. Even the best stocks can experience a price decline in cyclical markets. When you cannot afford even a temporary decline, puts can be used to lock in a striking price value.

Strategy 4: Pure speculation

Just as call buyers speculate on a stock’s price rising, put buyers accomplish the same result with puts. However, put buyers are hoping that the underlying stock’s price will move downward.

The rules for comparison between intrinsic, extrinsic, and time value are identical for puts and for calls, but with underlying price movement taking place in the opposite direction. So the more a stock’s price falls, the higher the premium value in the put.

Market sentiment plays a big role in determining the level of extrinsic value, of course. If the perception about a company is that its future is bleak, put value is likely to hold greater extrinsic value, notably for puts with a long duration remaining until expiration. However, if the optimistic view prevails and the perception is that the stock price will move upward, then put extrinsic values are likely to decline.

In selecting the best puts for speculation, several criteria should be in place, including:

1. The put’s striking price should be close to the current value of the stock.

Example

Putting the Matter to Rest: You have been watching a stock rise over the past month on what you consider overly optimistic outlooks for the company’s future. This includes a rumor that the company is a takeover candidate, which you do not believe. The rise in price has recently stalled and you expect the price to fall in coming weeks. You pick a put and buy it. The strike is slightly lower than current market value, which means the premium cost is quite low. You anticipate a fast change in the stock’s price, so you are less concerned with time value decline that you normally would be; if the stock’s price falls as you expect, the long put could become profitable very quickly.

2. Time to expiration has to be adequate for the stock to have time to make a strong downward move. This is a difficult judgment call.

3. As little extrinsic value as possible should reside in the put’s premium. This enables the put’s premium to be highly reactive to downward movement in the stock’s price. Otherwise, increases in intrinsic value will be offset by a decline in previously inflated extrinsic value, making it difficult to realize profits from put buying.

Defining Profit Zones

To decide whether buying puts is a reasonable strategy for you, always be aware of potential profits and losses, rather than concentrating on profits alone. Comparing limited losses to potential profits when using puts for downside protection is one type of analysis that helps you pick value when comparing puts. And when looking for a well-priced speculative move, time to expiration coupled with the gap between current market value and striking price—which dictates the amount of time value premium—will help you to find real bargains in puts. Premium level is not a reasonable criterion for your selection.

The profit and loss zones for puts are the reverse of the zones for call buyers, because put owners anticipate a downward movement in the stock, whereas call buyers expect upward price movement. See Figure 4.5 for a summary of loss and profit zones and breakeven point using the following example.

FIGURE 4.5 A put’s profit and loss zones.

Example

Canceling Out the Losses: You buy a put with a striking price of 50, paying 3. Your breakeven price is $47 per share. If the underlying stock falls to that level, the option will have intrinsic value of 3 points, equal to the price you paid for the put. If the price of stock goes below $47 per share, the put will be profitable point for point with downward price movement in the stock. Your put can be sold when the underlying stock’s market value is between $47 and $50 per share, for a limited loss. And if the price of the stock rises above $50 per share, the put will be worthless at expiration.

Before buying any put, determine the profit and loss zones and breakeven price (including the cost of trading on both sides of the transaction). For the amount of money you will be putting at risk, how much price movement will be required to produce a profit? How much time remains until expiration? Is the risk a reasonable one?

Another example of a put purchase with defined profit and loss zones is shown in Figure 4.6. In this example, the put was bought at 3 and has a May 40 expiration. The outcome of this transaction would be exactly opposite for the purchase of a call, given the same premium, expiration, and price of the underlying stock. You will gain a profit if the stock falls below the breakeven point of 37 (40 strike less 3 premium).

Remember this rule: As a buyer, don’t depend on time value to produce profits between purchase date and expiration because that is highly unlikely to occur. If you do not experience a price decline in the stock’s price adequate to exceed the price you paid for the put, then you will have a loss. Like call purchasing, time works against you when you buy puts. The greater the gap between market price of the stock and striking price, the more time problem you will have to overcome.

FIGURE 4.6 Example of put purchase with profit and loss zones.

The mistake made by many investors is failing to recognize what is required to produce a profit, and failing to analyze a situation to determine whether buying puts makes sense. Analyze these points in evaluating put buying:

• Your motive (leverage, reduction of risk, or downside protection).

• The premium level and amount of time value premium.

• Time remaining until expiration.

• Gap between the stock’s current market value and the put’s striking price.

• The number of points of movement in the underlying stock required before you can begin earning a profit.

• The characteristics of the underlying stock (see Chapter 7 for guidelines for selecting stocks appropriate for your option strategy).

Collectively, these guidelines define an investment strategy and work for you as tools for evaluating risks and identifying profit potential. You could earn substantial short-term profits; you also face a corresponding high risk level represented by time, the buyer’s enemy.

On the opposite side of the option transaction is the seller. Unlike buyers, sellers have an advantage with pending expiration. Time is the seller’s friend, and higher time value represents an opportunity rather than a risk. Because time value declines as expiration approaches, the seller benefits in the same degree as the buyer is penalized. You can purchase puts or sell calls and achieve the same strategic position, but the risks may be far different. Calls offer some interesting strategic possibilities for sellers, both high risk and very conservative. The next chapter examines strategies and risks of selling calls.