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Chapter 1. Stock Option Trading Further Defined

Buying Long-Term Calls for Tax Benefit

The idea in finance today is to make money, true, especially in stock option trading; but how much money net? What's left after tax? For that reason people look for long-term capital gains on which the tax is 25 per cent maximum. A man in the upper income tax bracket may have to pay a tax of 75 per cent or 80 per cent on his ordinary income, but the same amount of long-term capital gain calls for a maximum tax of 25 per cent. Instead of making a dollar, paying 75 cents in tax, and having 25 cents left, one is better off making only 50 cents on a long-term capital-gains basis, paying 12½ cents, and having 37½cents left. Therefore, in any form of capital asset, people look for capital gains opportunities.

In the securities market we know that to buy shares and hold them for over 6 months and make a profit creates a gain taxable at 25 per cent maximum. A profit made in less than 6 months is short-term profit, taxable at the same rate as ordinary income. To buy 100 shares of stock at 50 may result in a gain either long- or short-term—or it may result in a loss. And we don't know how much loss there may be. The Call option for over 6 months—usually for 6 months and 10 days—offers an unlimited possible gain and a limited risk. The risk is limited to the cost of the Call option contract.

The following illustrates this aspect of stock option trading. A man who expects a stock which is selling at 50 to rise, buys a Call option at 50, good for 6 months and 10 days, for $500. Notice the price of $500 for a 6-month option as compared to a 90-day contract for $350. The proportion is about like that—double the length of the contract for about 50 per cent more. If the expected rise materializes and the stock goes to, say, 70 after Mr. Trader has held the contract for over 6 months, he sells his Call contract instead of exercising it. We (and most option-dealers) will always be interested in buying a profitable option; in such instances, we will purchase the Call and exercise it for our own account (50), and sell the stock in the market (70) for our own account. The purchase price which we will pay for the Call will be equal to our net proceeds ($2,000.00), less two regular stock exchange commissions and any applicable tax. In selling such a contract, it has not been necessary to deposit margin with the option-dealer. It is my understanding that, in such transactions, the selling option-holder has ordinarily treated the profit as long-term capital gain on the sale of a contract held for more than six months.

It must be carefully noted, however, that if the holder of the contract exercises his option at 50 and at the same time sells the stock in the market at 70, such a profit is short-term gain by reason of the fact that the stock was held only one day. The holding period of the stock in this case does not date back to the time of the purchase of the option, but only to the time of actual acquisition of the stock.

Compare the two types of trades:

  Bought Call at 50 $ 500
  Sold Call at 50 with stock 70  2,000
  Long-Term Profit    $1,500

The tax on this would be 25 per cent or $375, leaving a profit after tax of $1,125.

If the Call had been exercised and the stock sold in the market on the same day, the account would read as follows:

  Bought Call at 50  Cost $ 500
  Bought stock at 50 by exercise of Call....      5,000
  Sold stock in market at 70   $7,000
  Short-Term Gain  $1,500

Consider this aspect of stock option trading, if this man's income put him in the 75 percent bracket, he would pay $1,125 in tax and be left with only $375 net profit after tax. While this procedure is extremely interesting, so is the action taken by the holder of an option that proves unprofitable. If the 6-month option is allowed to lapse, the loss—the cost of the option—is a long-term capital loss. A loss was sustained on a contract which was held over 6 months. However, if the contract which looks as if it will be a loss is sold to another for a nominal sum before the contract is held for 6 months—say 5 months and 20 days, or anything up to 6 months—the loss is a short-term loss.

  Bought Call at 50    $500
  Sold Call   1
  Loss       $499

Such short-term losses are valuable to the trader who might have short-term gains, for short-term losses are applicable against short-term profits.

Let us say that a trader has a short-term profit in securities or any capital asset of $500. He buys a Call option of two different stocks for $500 each. One Call is a loss, and he sells the contract in less than 6 months for $1. The other Call is profitable and he sells the contract after 6 months for $2,000 less the cost of his contract-$500. His result is a $1,500 long-term gain on the sale of one contract, and a short-term loss of $499 on the sale of the other contract. The $499 loss practically wipes out the $500 short-term profit and leaves an over-all long-term gain of $1,500, taxable at 25 per cent. Traders in securities would do well to understand this procedure.

As a side thought I would like to tell this story to do with stock option trading. It happened in November, 1957, after the market had had a severe break. A man with a southern drawl and wearing a big ten-gallon hat, walked into our office and wanted to speak to the "boss." "You know," he said, "I bought a lot of your Calls and I tore them up—lost my money." I thought maybe he was going to pull a gun on me. But my fear quickly vanished when he said, "Don't worry-how lucky it was that I bought Calls instead of stock. If I had bought the stocks way up there I would have gone broke." (The Dow Jones averages declined from 520 in July, 1957, to 420 in October.)

To buy an option, either a Put or a Call, and be wrong, can result in the loss of the cost of the option—that's all. But to buy a stock or sell a stock short and be wrong can cost a lot of money.

The Renewal of Options

Options can very often be extended and this should be thought about before stock option trading. Suppose you own a Call contract at 54 on a stock which has risen before the expiration of the option to 65. You feel that if you had more time, the stock could go higher—to 75, 80, or more—in another 60 or 90 days. Through your stock-exchange house or your option-dealer, arrangements may be made for an extension of the contract. The cost of an extension, if it can be made, depends on many things: the option price, the price of the stock in the market, the length of time of the extension, and, of course, the willingness of the original maker of the contract to extend the option.

The Exercise of Options Before Expiration

When looking at stock option trading, just because one holds a Call or a Put option for 90 days is no reason to wait until the last of the option time to act upon it. Many times a stock will rise considerably above the Call price or decline much below the Put price during the time of the option, but the holder of the option who does not take timely advantage of the situation may find that at the expiration most of the profit that had been in the contract has disappeared. For example, the holder of a Call contract at 50 having 20 days left out of a 90-day contract, finds the stock selling at 65, at which price he would have a nice profit if he would close out the contract. But he waits until the last day or near the last day, by which time the stock has declined to 54, wiping out most or all of the profit. A contract can be exercised at any time before the contract expires'.

The Effect of Options on the Stock Market

Consider, if you will more broadly look over stock option trading, what effect the exercise of options or the trading against options has on prices on the exchange. The effect is to stabilize. The buyer of a Put option is not a seller of stock as is a trader who sells, short. On the contrary, he is a buyer of stock and usually in a falling market. Let us consider the case of a man who, expecting the market to decline, buys a Put not on 100 shares but on 3,000 shares of a stock at 50. If the market declines to 40, and the man who owns the Put option is satisfied with such a profit, he may be a buyer of stock on a scale-down—500 at 40, 500 at 39, 500 at 38, and so on-until he has bought the 3,000 shares of stock covered by his Put option. His purchases strengthened the market on that stock.

I remember how, many years ago, a very large investor sold Put options in thousands of shares of a particular stock. The market as a whole became quite weak, but not this stock. Most of the holders of the Put options wanted to buy stock against their Puts and this action supported and stabilized the stock.

Call options also have a stabilizing effect on the market. The holder of Calls which are profitable closes them out by Calling or buying the stock which is specified in the Call contract and selling that stock in the market to complete the trade. A man who owns Call options becomes a supplier of stocks in a rising market. He sells the shares that he Calls in order to make his profit. Whether a man sells against his Calls in a rising market or buys against his Put options in a declining market, his actions are against the trend and, therefore, stabilizing and not destructive.

Effect of Dividends, Rights, and Stock Dividends

In stock option trading, on the day that a stock sells ex a cash dividend on the exchange, the prices in all outstanding Put and Call options on that stock will be reduced automatically by the amount of the dividend. For example, the holder of a Put option and a Call option, both at 50, will, on the day that the stock sells ex dividend $1.00 on the Exchange, automatically reduce both the Put and the Call option price to 49. While the holder of actual stock would be the recipient of such a dividend when it is payable, the holder of a Call option does not receive the dividend, but reduces the price of his Call option. Conversely, one who is short actual stock when it sells ex dividend would be charged for the dividend, while the holder of a Put contract reduces the price of his contract and pays the dividend only in the form of the reduced price when and if he exercises his contract.

Now in the case of rights issued on a stock, the prices in all outstanding options are reduced by an amount equal to the price at which the first sale of the rights is made on the day that the stock sells ex rights on the Exchange. Thus, if the first sale of the rights on the day the stock sells ex rights is 1V>>, then the price of outstanding Put and Call contracts would be reduced by 1% points. The stock at the opening on the day that the stock sells ex rights would probably open down l1/^ points so that there would be no advantage to either the buyer or the seller of the options.

Suppose that one owns a Put and a Call at 52 and the company has declared a 5 per cent dividend. From the day that the stock sells ex stock dividend the holder of the Call contract, if and when he exercises his Call, calls for 105 shares of stock for $5,200 (the dollar amount specified in the original contract) and the holder of the Put option, if he exercises his Put, will deliver 105 shares for $5,200 (the total dollar amount specified in the original contract).

As an example to help you understand stock option trading or simply think about it: the holder of a Call on 100 shares of American Motors at 20, with stock selling at 40 after it has sold ex a 5 per cent dividend, would Call for 105 shares of stock for $2,000. Conversely, the holder of a Put on American Motors at 20 if the stock were selling at 10 (after it had sold ex the 5 per cent stock dividend) would Put 105 shares of stock for the sum of $2,000. If the stock has sold ex a 50-cent cash dividend and then ex a 5 per cent stock dividend, the holder of the Call at 20 would reduce his Call price to 19^ and then Call for 105 shares for $1,950.

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