Playing It Safe With Put Plays

Also, sorting out multiple price listings and what happens to options in bankrupt companies.
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Holiday weekend? Not for the Options Forum. With stocks moving like barefoot beachcombers across the hot sand, we're pretty sure there are plenty of questions bouncing around the minds of investors.

This week, we address a few readers who want to use puts as a way to keep themselves and their capital safe. We'll be doing more on put plays in the next few weeks and using a guest columnist or two to break things down for us.

Enjoy the barbecue, don't forget the sunscreen and keep sending your questions to the

optionsforum@thestreet.com, and be sure to include your full name, OK?

So, What About Puts?

I read your introduction to equity options, and I understand calls. Now, how do I use puts in a bearish market? If you are supposed to sell covered calls to be safe, what do you do for puts? Puts are contracts to sell shares at a future date. Are they used in conjunction with short-selling to lock in a higher price today compared with, say, 45 days from now? Then you cover by exercising the put 45 days from now? This seems more complicated for the average investor than the covered call and probably just as risky as a naked call. Hey, and didn't a famous, longtime investor get burned last summer by buying puts? If I have something confused here, please let me know. -- Mike Morales

Mike,

You're making things a bit more complicated than necessary.

Puts are options that let you sell shares at a certain price by a certain date. They are used to profit from a downward move in a stock. That much, we can agree on.

How best to use them? There are two ways. Since owning puts is a short position already, you don't need to do it in conjunction with shorting stock.

What you would typically do is buy puts on stocks you already own. Doing this guarantees your exit price and cushions you from any continued slump in the shares. Owning the shares also provides you with stock to deliver if you want to exercise your puts at expiration.

Your other alternative, if you want to play the short side of a stock, is to buy the puts and be sure to sell them back before expiration. By that time, if the stock has fallen, the price of the put should have appreciated enough to make you happy and to provide a profit.

The famous investor you're thinking of is

Victor Neiderhoffer. He took a bath selling

S&P

puts against a market that was plummeting. Selling puts is a long strategy, not a short one, and that's what did him in when the market crashed.

Put-Selling Basics

I have been selling out-of-the-money puts on stocks I think are going up but do not necessarily want to buy. I am doing this with stocks I would otherwise buy because it seems a wiser use of capital to sell puts than actually purchasing the shares outright. What do you think is the proper relationship among the premium received, the current price and the strike price? When assessing one's exposure with the puts, what is the amount of capital one should maintain relative the amount that would be required to purchase the stocks that are subject to the put? -- Michael Sendowski

Michael,

Selling puts on stocks you would otherwise buy is a good move because, and only because, you are willing to own them and, we hope, like them over the long term.

Those facts, however, don't make your question easy to answer. It is difficult to find a mathematical relationship among the three prices you asked about.

We talked to a couple of pros about this one, some on the floor, some a bit removed from the action, and they unanimously pointed to volatility as a key indicator here. Be warned, however, because they each also pointed to gut feelings. "It's all about feel," says one West Coast floor trader.

Alex Jacobson of the

Chicago Board Options Exchange's Options Institute

teaches classes weekly about volatility and how to play it. He stresses that selling an option is almost always a vote on volatility. "Tell me where volatility is going to be tomorrow and I'll tell you which option is best to sell" is one of his favorite comments at CBOE seminars.

It may sound flip, but in the case of a stock such as

Cisco

(CSCO) - Get Report

, currently trading around a 45 to 50 implied volatility, you could sell an out-of-the-money put and watch it increase in value even if the stock doesn't move.

Jacobson reminds us that an at-the-money put is the measure of downside risk in a stock and that the at-the-money straddle (the combined cost of the puts and calls closest to the underlying stock price) is the absolute measure of risk (or volatility).

So, essentially you can determine the volatility by figuring out the multiplier that gets you from the cost of the straddle to the price of the underlying stock. For instance, on a 90-day option, if the at-the-money straddle price multiplied by 12 gets you the underlying stock price, the volatility is about 20%; multiplied by 8 would be a 30% volatility, and by 6, a 40% level.

So you won't necessarily do any better selling high volatility puts to get a bigger premium, unless you can divine the next day's volatility.

But remember, selling puts is a good strategy only when you pick a purchase price with which you're comfortable and on a stock you are willing to bottom-fish and hold. It is probably the most risky of basic options plays and has left many owning $80 stocks at $95.

On the matter of how much cash to keep handy, Michael Schwartz, senior options strategist at

CIBC World Markets

says 100% of the purchase price is ideal. If not, then 50% of the purchase price and enough borrowing power to grab the other 50% on margin should suffice.

The

New York Stock Exchange

mandates 20% of the purchase price on the sale of uncovered puts, but many firms set higher levels for their clients.

Multiple Listing Disorder, Part II

I've had a few cases lately where an order to buy or sell doesn't execute in the way I would expect. The common denominator in all cases has been that the option I'm trading is listed on multiple exchanges and my broker routes the order to an exchange other than the one I've got quote data for. Can you answer a couple of questions related to this? Is it reasonable for me to expect my broker to route the order to the exchange that shows the best bid or ask at the time of order entry? Or should it be necessary for me to direct them to route the order to a specific exchange based on my own data? I'm currently unable to do the latter because I don't have the software. Are you aware of quote software that will let me see bid/ask data from all exchanges that list a particular option? My current software will only give me data from the primary exchange. -- Art Welch

Art,

In theory, the options market is efficient enough that there shouldn't be a large disparity between the prices of the same option on different exchanges. If it were less efficient, floor traders would be busier arbitraging the difference than accommodating customer orders.

The disparities you see on your screen disappear quickly if an order is sent to the market that might be showing a different price.

It works like this. The CBOE is the secondary market for XYZ.com and has traded 20 of its June 50 calls, and the

Pacific

is the primary market and has traded 500. If the CBOE market is lower, it's likely that it traded earlier and that its last price isn't reflecting what the market is currently worth.

If another trade hit the CBOE, it's likely that market will catch up to the Pacific quickly.

More important, you want to keep most of your trades going to the primary market. That's where you're more likely to get the best price. Remember, most retail orders are now executed automatically, especially at the CBOE, so you'll pretty much always get the market.

Any of the major vendors should be able to provide quotes for each of the exchanges on which a particular option trades.

Bankrupt Options

I have a very short question: What happens to options (both puts and calls) if the company goes bankrupt? Are they worthless after this or something else? -- Denis Nikitin

Denis,

A short question, with a nice long answer.

Generally, options don't just vanish into thin air if a company goes under. It depends on two factors: what happens with the stock price and current exchange rules about listings and market capitalization.

Options liquidity, of course, depends on how liquid the stock is. Let's say a company declares bankruptcy and the stock becomes worthless. The calls, obviously, aren't worth anything, but the puts can still be exercised to sell the stock. The person who wrote those puts is still obligated to buy the worthless shares for the strike price at which they sold the option. And even if they don't carry their end of the deal, the

Options Clearing Corp.

will back the contract.

If this sorry stock drops so much that the companies no longer meet exchange listing requirements, the options that have already been issued can still be exercisable at expiration. But the exchanges have the right to stop the creation of new options series.

IRA Options Play

I've read that options trading, other than just covered call writing, can be done in an IRA. Do you have any info on this? -- Jonathan Pagano

Jonathan,

Usually, investors use options to hedge against their portfolio, even in an IRA.

It's definitely not illegal to do more than covered call writing, as long as you're hedging against your stock portfolio.

What our friends at the

Internal Revenue Service

don't like is when investors use options to hedge against other options. For example, if you buy January 50 calls and sell January 55 calls to finance the trade, you are hedging an option against another option. That's a no-no.

The IRS does allow something called a "risk-reversal." That's when you buy a protective put, write a covered call and use the proceeds to pay down the cost of the protective put against your long stock position.

Let's take

Microsoft

(MSFT) - Get Report

, which closed at 78 3/8 Thursday, as an example.

You own the stock and want to protect your downside, so you buy a put in case the stock collapses. An October expiration put will cost you $7. But in order to pay for that put and give yourself a little upside, you write an out-of-the-money call against it at a strike price of 82 1/2. Usually investors do this with LEAPS (Long-Term Equity AnticiPation Securities). If the stock's at 85 by October, the puts are worthless. But oftentimes investors will simply roll out that same risk-reversal position with a new trading range, out a few months to continue to protect against downside risk.

"That's a possibility in your IRA. We allow our customers to do it," says Brent Houston, managing director with

Mr. Stock

, an online brokerage firm in San Francisco. "What we don't allow customers to do are spreads, that is, buying a call spread or put spread or selling naked options."

So what's OK? Buying protective puts and selling covered calls against your long stock position on a one-to-one basis. "That's pretty restrictive, but remember, the IRS wants people to invest, not speculate," he adds.

TSC Options Forum aims to provide general securities information. Under no circumstances does the information in this column represent a recommendation to buy or sell securities.