Smarter Money: A Puts Primer, Part 1

When someone big sells puts on an index, that index is likely to: a) go down? b) go up? or c) do nothing. If you answered anything but b, this column is for you. Hit the "print" button, take this one home and study it. It will explain something that must be understood if you are going to play or understand these treacherous markets.

Nothing confuses people like puts. Nothing. They are one of these devices that everybody dreads writing about because they are difficult to understand. So let's start very simply. If you want to make a bet against a stock you can short that stock or you can buy a put on it. They are virtually the same thing.

First, let's talk about what puts are not. Let's say you want to bet that National Gift Wrap is going to fall from 50 to 40? You can sell 1,000 shares of National Gift short at 50 and, when it gets to 40, you can buy or "cover" the stock and make 10 points. Ten points times 1,000 shares is $10,000.

Now, let's say you make this same bet, but this time the stock fails to go down. In fact, it rallies 10 points as National Gift has an exceptional holiday season. Now you are out $10,000. You sold the stock at 50, it rallies to 60 and then you buy it. You lose $10,000. Of course, you don't have to buy it, or "cover," but it could always go up even more!

Now let's say National Gift gets a takeover bid from International Packaging Products at 80. Now you are out $30,000 (30 points times 1,000 shares). That's a disaster plain and simple.

So brokerage firms have created products that allow you to participate in the downside and have what is known as "defined risk" on the upside. They are called puts. They are a very useful -- and often a very liquid -- method of betting with defined risk. You can't lose an unlimited amount of money as you could in those stock examples from above.

So let's go back to the first example.

National Gift is at 50. You think it is going to 40. You can buy a put on National Gift that will limit your risk to the upside but capture a substantial amount of the downside.

You might be able to buy the National Gift 50 put, a put struck at 50, that allows you to capture all of the downside for a price of $3 going out three months. (The "strike" is the level that you chose to bet from. You could buy the 55 strike or the 45 strike. The higher you go, the more dollars you will have to spend. The lower you go, the fewer dollars.)

If you buy a put struck at 50, and you pay $3 for it, below 47 you begin to make money. (50 minus the $3 put. View the put as the vig, or the cost of admission.) If you were to buy 10 puts you would have the same fire power as that 1,000 shares short from the previous example. (One put equals the right to sell 100 shares; 10 puts equals the right to sell 1,000 shares.) Sure, you wish you wouldn't have to pay so much for that put, relative to being short the stock at the actual price, not three points lower. You don't do so well if the stock only drops to 49 or 48. In fact, you lose money where you would have been winning with an outright short of common stock.

But think about the consequences when International Packaging bids for National Gift. You are out only the three bucks. That's defined risk. That's how you can bet against stocks and sleep at night. In this tape, that's not such a bad idea.

By the way, I am theorizing that the price would be $3. For this piece of business -- a "10-lot" -- there might be many buyers and sellers, and the market makers would quote you a price that would make sense given the volatility of the stock, the time period covered in the option and the dollar amount of National Gift. You can move in and out of smaller lots of options with ease. There are always buyers and sellers willing to accommodate.

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Editor's note: Please read Part 2 of A Puts Primer!

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