The Put Option: Flexibility on Steroids

By: Don Heggen
Submitted: 2007-01-17 16:16:38
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What is a Put Option?

In stocks, it's a standardized exchange-traded contract that gives the buyer the right, but not the obligation, to sell a specified amount of stock (quantity), at a specified price (strike price), by a specified date (expiration date), for which the buyer pays a price (premium) to the seller.

Options trade just like stocks until the last trading day which is always the third Friday of the expiration month.

Option prices have two components: Intrinsic value and time value.

Intrinsic value is the amount by which the strike price is in the money. If the strike is out of the money, there is no intrinsic value.

Time value is the amount in excess of the intrinsic value.

Options may, or may not, have intrinsic value but they all have time value.

Comparing the strike price to the market price, options are described as being at-the-money, in-the-money, or out-of-the-money.

Depending on its use, the Put Option can provide protection, trading profits, or income as follows:

(1) As a form of insurance, protecting long positions against loss.

(2) Trading profits, as a substitute vehicle for short sales, in declining markets.

(3) Income, in the form of premiums received, from selling put options.

Examining the use of each in more detail, we find:

First, as a form of insurance, the simultaneous purchase of stock along with the nearest in-the-money Put Option fixes the amount at risk to the options' time value only: Stock price + Put price - Strike price = Risk. If the implied volatility is low, that's a cheap risk!

Second, as a trading vehicle, the purchase of a Put Option is superior to the short sale of stock, for the following reasons:

(1) Stock may not be available for lending (short stock has to be borrowed).

(2) Limited risk (no margin calls).

(3) Easier order fills (No "up tick" rule).

(4) Greater leverage (Put Options are cheaper than margin requirements).

(5) No dividends to make up (short sellers have to pay dividends back).

(6) Long term capital gains tax treatment is possible, if the Put Option lasts over 1 year (short sales can never qualify for long term capital gain treatment, no matter how long the position is held).

Need I go on?

Here's a clue: In deciding which option to buy, never choose at-the-moneys (too much time value).

The longer your time horizon, the nearest out-of-the-money will give you better leverage.

Two strikes in-the-money provides higher delta which means greater price correlation to the underlying stock. The deeper in the money, the higher the delta; the higher the delta, the higher the correlation to the stock, almost tick-for-tick. How sweet it is!

Third, many investors, without ever owning the stock, make a living from selling Put Options for the premiums they take in.

In this respect, they're like insurance companies selling "insurance" for the premiums and, of course, they steadily reinvest all those premiums. It's called "compounding", you may have heard of it back in your grade school math class. It's not without risk. Sometimes they have to pay off by having the stock "put" to them.

When your game is selling options, your profit comes from selling time value (otherwise known as "air" or "puff") and either buying them back cheaper or having them expire worthless and then repeating the process over and over and over again and again and again.

Get the idea?

Uncovered (aka "naked") options can only be sold in a margin account but, if you invest in T-bills and put them up as your collateral to meet your margin requirements, you get to take in interest and option premiums all at the same time. Can you say, "double dipping"? It does whole bunches of good for your ROI (return on investment).

And if the market should not cooperate by going into a decline? A follow-up strategy known as "rolling down and out" may be deployed.

Rolling down and out is a defensive maneuver where you buy back previously sold options and simultaneously sell new ones at lower strikes prices (rolling down) and further out in time (rolling out) to gain more time value (remember "air"? "puff"?).

Put Options: Flexibility on Steroids!

Because No One Cares More About Your Money Than You

http://dynamic-stock-market-strategies.com

Good trading,
Don Heggen

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