Home  |  Get Started  |  Download  |  Advertise  |  Donate  |  Contact Us
Chapter 1. The Put Option Contract Explored

Uses of the Put Option Contract

In all of the following examples, for the sake of better understanding, I will try as much as possible to use one figure for the price of the stock and one figure for the cost of the put option. Understand, please, that these prices change in actual practice. The cost of an option on a stock selling at 50 would be less than one selling at 80 and, likewise, the cost of an option for 90 days would be less than one for 6 months on the same stock. The price of an option usually depends on the price of the stock, the duration of the option, the volatility of the stock, and supply and demand for the options in question.

Buying a Put Option for Speculation

A man who thought that a stock selling in the market at 50 would decline to possibly 30 could buy a Put option. In buying an option, he should have some idea to what extent the stock might move. In inquiring what a Put option would cost, he might receive a nominal quote of, say, $350 for a Put at the market for 90 days. Most options are negotiated "at the market," which means at "the current market," when the option can be obtained by the option-dealer. Suppose that the stock is selling at 50 and the quoted price of $350 is satisfactory to you. You enter your order: "Buy a 90-day Put on 100 XYZ [the name of the stock] for $350." If you are trading through your stock-exchange broker, he will give your order to an option-dealer who will contact one of his clients who sells options on that stock and will attempt to buy the option for you. When, after this contact or several others, he has obtained the Put option for you, he reports to the stock-exchange broker who gave him the order, and he in turn reports to the customer: "Bought Put 100 XYZ at 50 expires December 30 for $350." Let us say that the man who bought the Put option, expecting a decline in the stock, was wrong, and that the stock, instead of going to 30 (as he expected), advanced to 70 and was selling there when his option expired. He would have lost the $350 that he paid for his Put option. Bear in mind that the limit of the man's loss was the cost of his Put option, or $350, no matter how high the stock rose and no matter how wrong he was, and that he would draw on the equity in his account to that extent only. Suppose, on the other hand, he had sold the stock short in the market. His loss would have been 20 points and still no knowledge as to the possible extent of loss until he covered the short sale. But in the purchase of the Put option his account would read:

Bought Put on XYZ at 50 for 90 days: Loss      $350

Remember, too, that no trade has been made in the stock, so no stock-exchange commission has been paid. A regular stock-exchange commission is charged by your broker only if a transfer of stock is made in connection with the option.

On the other hand, suppose the man's judgment was correct and the stock declined to 30. If he had instructed his stockbroker to buy 100 shares at 30 and exercise his Put option, his account would look like this:

  Sold 100 shares at 50 (through exercise of Put) $5,000
  Total Receipts   $5,000
  Bought 100 shares in market at 30 3,000
  Bought Put at 50  
  Cost     350
  Total Cost   3,350
  Profit on trade  $1,650

The profit then would be almost 500 per cent of the cost of the Put contract. The profit is the difference between the cost of the stock plus the cost of the Put option and the proceeds of the Put that was exercised.
In all of these examples showing the use of options, the commission cost has been ignored. But at no time could the loss have been more than the cost of the option— $350—and any stock-exchange commissions would have been paid out of profit or out of possible recovery of part of the premium which was paid.

Trading in Odd Lots Against a Put Option

In the aforementioned example of trading against an option, the trading was done by buying 100 shares of stock at 30 and selling the stock at 50 through the exercise of a Put option.

Another way of operating against such a Put option is to buy stock in odd lots of, say, 25 shares each on a scale-down as follows: the holder of a Put at 50 might buy 25 shares at 36, 25 shares at 34, 25 shares at 32, and 25 shares at 30. Of course, each purchase in the market must be margined according to stock-exchange regulations, but the man who has no definite opinion as to where the stock should be bought against his option "scales" his buying orders until he has bought 100 shares, and then he may, if he cares to, deliver these shares against his Put option contract.

His account would then read:

  Bought 25 shares at 36 cost $ 900.00
  Bought 25 shares at 34 cost

850.00

  Bought 25 shares at 32 cost        800.00
  Bought 25 shares at 30 cost 750.00
   

$3,300.00

  Cost of Put 350.00
   

$3,650.00

  Sold 100 at 50 through exercise of Put

 $5,000.00

  Profit

$1,350.00


If, however, the contract has some time to run, he may want to hold the stock, which he bought, looking for a rally and a chance to sell his stock in the market and thereby leave himself open to repeat the operation, if possible.

Trading Several Times Against an Option
Suppose that instead of expecting a severe decline, the trader expected that we would for the next few months have a market that would be a "trading market," one that would fluctuate mildly. The ability to use an option to trade against can be quite profitable to the holder, for many trades can be made against the same option, and each time a trade is made, that trade is fully protected against unlimited loss if the trader's judgment should be wrong. For example, let us say that a man buys a Put option on 100 shares at the current market price of 50 for 90 days for $350. In a few days the stock declines to 46, and the trader, feeling that the drop has been enough for the moment, buys 100 shares at 46 through this stockbroker. He must deposit the normal margin required for such a purchase as the option cannot be used for margin. In making such a purchase, he is guaranteed against loss because the holder of the Put option can, up until the expiration of the Put contract, deliver his stock at 50 at his option. Now he is holding 100 shares which cost 46, and since his Put option guarantees that he can sell it at 50, he is assured of no loss. Say that in the next week or so the market rallies and the stock rises to 51 and the trader decides to sell. To recapitulate: the trader bought stock at 46 and sold it at 51, yet he still retains his Put option, which does not expire for some 70 days. He has made a gross profit of five points and may have further opportunity of making additional trades—and each time he buys stock under the price of his Put during the life of his option contract, he is guaranteed against loss.

After having bought stock at 46 and sold it at 51, the same trader might, if the stock declines again, have another opportunity to buy more of it and, after another rally, have another chance to take a profit. The number of opportunities to make such trades is limited only by the fluctuation of the stock in the market and the trader's ability to judge the stock's movements. The reader should realize that it might be possible to make many such trades during the life of an option. Note that a trade or trades against an option do not nullify the option contract. The contract is operable until it expires or is exercised.

Buying a Put Option to Protect a Profit

A man owns 100 shares of stock which he bought at 30 four months ago. Now the stock is selling at 50. Concerned about conditions but feeling that his stock can do still better, he buys a Put contract at 50, good for 90 days, for $350. I would like to call the attention of the reader to the fact that the $350 paid for the protective Put can easily be more than made up by the fluctuations of the stock in the next 90 days.

Suppose that when the Put option expires, the stock has declined to 30. Without the protection of the Put option, the man's profit would have been lost, but through the terms of his Put contract he delivers his stock at 50 to the maker of the option. The 20 points that he has saved through the use of his Put has certainly more than paid for the cost of the option. He can, if he cares to, now repurchase at 30 the stock that he sold at 50 through exercising his Put option.

On the other hand, let us suppose that when the Put expires, the stock has advanced to 70. While the buyer then allows his option to expire (he wouldn't Put stock at 50 when he can sell it in the market at 70) the 20 points appreciation in the stock has more than made up the cost of the Put. Only if the stock is at about the same price of 50 when the option expires will the $350 paid for the contract be an actual loss. Even then it must be admitted that the Put has furnished protection during the period of the option.

Note that the holder of an option will and should exercise his contract even if the exercise will return to him only part of the cost. If the holder of a Put at 50 finds that at expiration the stock is selling at 48, or even 49, the contract should be exercised so as to recover part of the premium instead of losing all of it.

  Bought Put at 50-cost

$350

  Sold Stock at 50 by exercising Put

$5,000

  Bought Stock in market at 48     $4,800
  Profit on Stock $200
  Loss between profit on stock & cost of Put Option.  

$150

   

 

An option should be exercised even if only part of its cost can be salvaged.
Buying a Put Option to Protect an Initial Commitment

Feeling bullish on a stock, a man wants to buy 100 shares but does not want to assume a big risk. He buys 100 shares at 50 and at the same time buys a Put option at 50, good for 90 days, at a cost of $350. Through the protection of his option, he knows that he can share in any rise of the stock but his loss will be limited to the cost of his Put contract. To be practical, let us see what happens if the stock goes up to 70, as he expects, or what happens if he is wrong and the stock goes down to 30. In the first instance he would sell out his stock at 70 and let the Put option lapse, and his account would read:

  Bought 100 shares at 50

$5,000

  Bought Put 100 shares at 50-cost 

$350

  Total Cost     $5,350
  Sold 100 shares at 70   $7,000
  Profit

$1,650

   

 

This profit has been made with a risk of $350.

If he had been wrong and the stock had declined to 30, his account would have read:

  Bought 100 shares at 50

$5,000

  Bought Put 100 shares

$350

  Total Cost     $5,350
  Sold 100 shares at 50 (through Put)   $5,000
  Loss

$350

   

 

Note that he sold his stock at 50 (at cost) through the terms of his Put contract, even though the stock had declined to and was selling at 30.

Are You Ready To Move Onto The Next Lesson? Click Here….

Add URL | Contact Us | Privacy Policy | Option Trading Strategies Sitemap | Resources
COPYRIGHT (C) 2005 www.optiontradingstrategies.org