Buying a Put
In the previous section I discussed the use of a Call option in place
of buying a stock that you think will increase in value. In this
section I will discuss the use of a Put option is place of shorting a
stock you think will decrease in value. Most people are familiar
with the buy low—sell high logic of buying a stock, have it increase in
value, and selling it for a profit. Shorting a stock uses a
reverse strategy of sell high—buy low. When you short a stock you
borrow the stock and sell it at the current market price and then buy
it back at a lower price if and when the stock drops in value.
There are two issues that you must consider when you short a
stock.
- You must pay interest on the borrowed stock
- If the stock increases in value you are subject to unlimited loss when you have to buy back the borrowed stock.
- Shorting a stock is not allowed in all accounts, most notably IRA accounts.
A
Put option gives the buyer of the option the right to sell the
underlying stock at the Strike Price until the Expiration Date.
The buyer of a call is bearish on the stock. Suppose you think
Microsoft will have an adjustment problem in the first 6 months after
Bill Gates retired. On July 18, 2008, Microsoft closed at 25.86
and you could have sold 100 shares short for $2586 which would be
credited to your account. Suppose that in 6 months, the stock
decreases by 15%. The stock would be worth 21.98 and you would
have a 15% gain or 3.88 points. However the interest you pay on
the borrowed stock and the interest you get on the sale of the stock
results in an average loss of 7% (This will vary from broker to
broker.) or $90 for a net gain of $298 or 12%. Not bad for half a
year.
Now take a look at what you could do with a Put option.
You could buy a Put option with a Strike of 27.50 that will expire on
January 16, 2009 for a Premium of 3.20. If Microsoft showed the
same 15% loss to 21.98, the option would be worth the Strike Price,
less the Stock Price, less the Premium paid: 27.5-21.98-3.20 =
2.32. This is a profit $232 on an investment of $320 or
72%.
Option Strategies. Is a listing of the various ways to use option.
Kaboom Forum. Allows you to discuss on the KaboomStocks
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