The smart money, particularly in the technology sector, went short this spring and made a bundle. But in addition to being smart, this money had to be brave as well, because shorting volatile stocks can be a risky and costly endeavor.
This week's Options Forum will take a look at how investors can profit from taking a safer short position through using equity options, or to use puts as insurance against a long position in the underlying stock.
Buying put options is the simplest method and best known way to use options to either take a speculative bearish position on a stock or to protect yourself against a downdraft in the stock if you're long the stock.
A put option gives the buyer of the contract the right, but not the obligation, to sell the underlying security for a specified price (the strike price) by a certain specified time (known as expiration. The investor has until the close of trading on the third Friday of the month in which the contract expires to exercise the option).
For example, Jerry thinks
is going to tank and by September, he thinks the stock, which is trading at 60, is going to be a lot lower than that by late September. Instead of a short sale of the stock, Jerry buys an out-of-the-money put option on Cisco. (A put option is out-of-the-money if the underlying stock price is above the strike price and the put is in-the-money if the stock price is below the strike price.)
He buys a September 55 put option for 3 ($300).
To break even on the trade, Jerry needs Cisco to fall to 52 (55-3) by expiration. If the stock falls close to that, he can also sell the option before expiration for a higher price than he paid.
If Cisco does the opposite of what he expected and rallies, the most Jerry can lose is the premium he paid, $300 for the contract. Since Jerry felt so confident that Cisco was going to tank, he bought an out-of-the-money put, which was cheaper than an at-the-money or an in-the-money put.
If Jerry is really prescient, or probably more accurately, a bit lucky, Cisco falls to 45 by the time expiration rolls around. So on expiration day before the close, Jerry buys 100 shares of Cisco at 45 and simultaneously exercises his put option at 55, making a profit, minus the premium he paid of $700. (Jerry buys Cisco for 45, paying $4,500 for the stock and exercises the put, selling the stock for 55, or $5,500. Subtract the premium he paid for the put, which was $300, and Jerry's profit on the trade is $700).
Jerry's other alternative -- selling the put option to close out the position -- works like this. Jerry bought the September 55 put at 3 ($300), but as the price of the stock drops and goes into the money, until it hits 45, the value of the contract rises sharply, a heck of a lot higher than the 3 he paid for it. Say 45 is Jerry's downside objective for the stock and it's early September and he doesn't see much more downside in the stock, and since there's a little time value left in the option's price, Jerry decides to sell the put and close out the position.
The premium for the contract now is 11 around the time when expiration rolls around and Jerry sells the contract back and closes the position, taking in $1,100, minus the $300 he paid for the contract, he pockets a profit of $800.
The Joy of Hedging
Buying a put is also used as a hedging tool against a long position in a stock. One way to do this is through what is called a "married put," where an investor buys the underlying stock and purchases a put option simultaneously. For example, Shelley buys 100 shares of
for 50 a share and simultaneously buys a September 50 put for 5 ($500) because she isn't sure how drug stocks are going to do this summer, so she wants to protect herself.
By doing this, Shelley has bought insurance that no matter what happens in the performance of Pfizer stock, she can sell it at 50. So, if Pfizer drops to 40, the most Shelley can lose on the trade is what she paid for the put, which is better than the risk she may incur if the stock really goes against her if she had not bought the put.
It works like this: If Shelley is exclusively long 100 shares at 50, she lays out $5,000. If the stock falls to 40, she loses $1,000. If she had the put, and exercised it to sell Pfizer for 50 when it was trading at 40, she only loses the $500 she paid for the put.
In the bull market of the past few years, investors may have lost their appreciation for a little insurance. The past few months, however, show that whether you're a bear on a stock, or just want to protect the positions you're already in, buying put options is a way to keep yourself in the game.