Which is safer, selling short or buying puts? -- B.C.
Buying puts is safer. The risk in owning puts is limited to the cost or purchase price of the put options, but the potential risk associated with shorting shares outright is unlimited. Also, depending on the strike price and expiration date, the cost to purchase a put option is typically significantly less than the initial margin required for shorting the shares.
The lower capital requirement can result in higher percentage returns, and losses, given the same movement in the underlying shares. Because it is not unusual for options to expire worthless, which results in a 100% loss, it is advisable to base the number of options purchased to the maximum dollar amount you are willing to risk or to equate to the number of shares you would like to short.
buy the dollar amount of puts you would have committed to shorting the stock. Due to the leverage of options, and the possibility of the options expiring worthless, a committment of this much capital to the purchase of options carries an inordinate amount of risk -- potentially even greater than shorting the shares outright.
For example, if you planned to short 1,000 shares of
at $67, which would require a $33,500 initial margin, you might consider buying 20 January 2006 $65 puts for $6 per contract, which will cost a total of $12,000. (See the next question for why I chose this example.)
The put position will have the same initial delta as being short 1,000 shares, but it has a greater profit potential in both percentage and absolute terms. A decline to $50 will result in a 150% gain on the puts but just a 50% return on the short stock. And the put position controls twice as many shares as the short (20 puts equates to 2,000 shares). The absolute dollar return for a decline to $50 would be an $18,000 profit on the puts compared to a $17,000 profit on shorted stock.
It is worth repeating that the down side of owning options is that they are a decaying asset. That means the puts can lose 100% of their value even if the stock remains unchanged or even declines slightly, because any price above $65 renders the put worthless. The break-even point is $59, or 11% below the current price. Again, it would not be advisable to buy $33,500 worth of puts, which, in this case, would equate to around 55 of the January 2006 $65 puts.
My question revolves around purchasing LEAPs as an opportunity for longer-term bearishness. Specifically, I would like to purchase Jan 2006 LEAPs but when I look at the LEAPs for WHR, as an example, they don't trade and the current quote, bid and ask are vastly different.Can you explain how LEAPs can be best purchased for this type of plan or if there are better ways to play out my theory? Thanks in advance for your input.
Purchasing LEAPs (Long-Term Equity AnticiPation Securities) is definitely an appropriate strategy for establishing a bearish position. See the aforementioned answer for its advantages over shorting stock. But, as this reader describes, one of the obstacles, aside from overcoming the time decay, is trying to execute an order in an illiquid or thinly traded market.
There is no easy way to overcome a thin market with a wide bid/ask spread -- the two kind of go hand in hand. If you really want to establish the position, you may simply have to pay the asking price. Currently I see Whirlpool's January 2006 $65 quoted at $5.70 bid/$6.00 ask. Remember, options are always quoted at the price at which someone is willing to trade. The fact that a given strike might not trade for days on end simply means no one has been willing to pay the price to entice a counter party.
Because most market-makers are very short-term traders, they need only a relatively small edge to yield a profit, and their gain does not necessarily come at your loss. So, while it may not feel good to "pay-up" and add 30 cents extra premium or additional cost associated with lifting the offering, in the scheme of a yearlong position in which you are looking for a substantial move, it is not so terrible.
One approach you might consider is to use a vertical spread trade, in which you buy puts with a higher strike or deeper-in-the-money and sell an equal number with a lower strike price. This will help increase the break-even point, remove most of the volatility risk and also offset some of the time decay. But it will also limit the profit potential. Again, you still will likely have to "pay the asking price" but with a spread sometimes you can split the difference between the bid and the ask.
Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to