Saturday, February 22, 2014

The Long Put

Here is the “other” conservative method to use options, the long put. Think of it as buying insurance against a sudden dramatic drop in the price of your current holdings.

A put option, commonly called a put, gives the owner the right but not the obligation to sell a given number of shares (100 shares per contract) to the seller of the put at a specified price on or before the maturity date of the contract. In European option trading the contract can only be executed on one specified date.

John is concerned about his shares of XYZ Company. The CEO of the company just died of a heart attack. No one is certain how this will turn out. Everything may go on as before, or maybe things will get worse. John decides to look into buying a put on his 100 shares of XYZ that are currently trading at $50 a share. As before, he purchased these shares at $30 five years earlier. John discovers that he can purchase a put that will guarantee the current price of $50 a share that expires in six months for $.50. That would be $50 to cover his 100 shares. John executes the trade.

Judy, who sold John the put option, thinks it will never be executed. She believes the directors of the XYZ Corporation will promote Snidely Whiplash, current CFO, to the top spot. Investor confidence should then cause the stock price to jump significantly. She is quite willing to take John’s $50 premium to guarantee a share price of $50.00.

Judy was right. She gets to keep the $50. The share price went to $60 a share. John sells his shares making a $3,000 profit less the $50 cost of the premium.

Judy was wrong. The price of XYZ drops to $30 a share on the news that the top job has been filled with the founder’s grandson, a man the market considers something less than the sharpest quill on the porcupine. Judy must buy John’s shares at the $50 strike price when she could have purchased the same shares for $30 on the open market. She loses $2,000 when John executes the put, although she still gets to keep the $50 premium. As guaranteed by the put, John makes $2,000 when he “puts it” to Judy.

As a conservative investor, I can imagine situations that might lead me to buy a put option at a reasonable price to protect myself in an uncertain environment. However, I can’t imagine selling a put unless I was getting an awfully generous premium.

For heaven’s sake, “Let’s be careful out there!”

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