Why Companies Sometimes Bet Their Stock Price Will Fall

Also, we explain the long and short of buyers and sellers, and puts and calls.
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This week we'll scrutinize the very popular option-selling programs employed by publicly traded companies, such as

Microsoft

(MSFT) - Get Report

, that involve buying put options on their own stock.

Plus, readers sock it to us.

TheStreet.com

got plenty of pointed email regarding the Sept. 28 story

Selloff Leaves Holders of Naked Puts Feeling Undressed asking that we clarify "holders." Did we mean sellers or buyers? We'll tackle that question as well.

Meanwhile, keep sending your options questions, with your full name, to

optionsforum@thestreet.com.

Puts and Corporate Stock Buybacks

I must admit I am confused. I own Microsoft -- a lot of it -- and I was shocked to read of the company buying put options, which I thought you buy if you believe a stock will go down, not up. Why not just buy the shares anyway? -- Emanuel Rosen, M.D.

Emanuel,

It sounds like what you're asking about is Microsoft selling, or "writing," put options as part of what are increasingly popular corporate stock-buyback and option-selling programs.

Why do big companies such as Microsoft and

Dell

(DELL) - Get Report

sell options just as they're buying back stock?

Simple -- to make more money.

"Microsoft right now is authorized to do a stock buyback. By selling options, they're trying to optimize their stock buyback in the most profitable way," explains Adam Benowitz, managing director of

Apex Capital

in Spring House, Pa., a consulting and money-management firm. Before forming his own hedge fund, Benowitz was a floor trader in options on the

American

and

Philadelphia

exchanges.

Microsoft's option program involves selling puts, which are generally thought of as bets that a stock will fall.

In this case, Microsoft doesn't mind if the price falls. When buying back its own stock, the lower the price, the better. By betting that the price will fall, Microsoft makes money selling put options

and

gets its stock at a bargain (assuming the price actually does fall). "It's maximizing the profitability of the stock buyback," Benowitz says.

"Right now, Microsoft trades at around 90," Benowitz explains. "Let's say the stock gets down to 80, the company will be buying the stock at 80. And let's say they sold puts for 8; they're really buying the stock at 72. They either keep all the premium

if the price of the stock doesn't fall or buy the stock back at a price they want."

Overall, Benowitz says, "It's a great strategy. The only way it would backfire is this -- if Microsoft planned to buy the stock back and they didn't follow through. I remember Dell some years ago was playing in currencies; the company said they were hedging, but they were really just speculating. Somebody in the finance department goes nuts, starts playing the market and creates a disaster. But that's not the case here."

Seller or Holder?

In the Sept. 28 column, don't you mean "sellers," not "holders," of naked puts? I thought the buyer "held" the put the right to sell until he decides what to do with it. The buyer holder doesn't know or care whether the put was sold "naked" or not. I find your terminology confusing. If I am wrong, and the seller is considered the "holder," then I would appreciate being straightened out. -- Stan Adams

I wish to point out that a seller of a naked put is NOT a "holder" of a put. Your headline was a bit misleading. The "holder" of a put is the one who is LONG the put, not SHORT. -- Bob Bloch

Boy, nothing gets by our readers. Stan and Bob are right: We should have said "sellers," not "holders." We asked Adam Benowitz to explain further:

"So, the column was discussing naked puts," or put options which aren't accompanied by underlying stock, Benowitz recalls.

If you've bought puts, oddly enough, that means you are "long" the puts: Your risk is definable -- you can only lose as much as you spent on the option. What if you sold the puts? Then you are "short" the puts, and the risk is much greater.

"What Lafferty and other firms are worried about in this volatile atmosphere is a customer with a 'short' position in naked puts. Someone who is 'naked' short puts is someone who's sold, or written, puts and didn't bother with a position in the underlying stock as a hedge," Benowitz says.

Benowitz draws an example: Take

IBM

(IBM) - Get Report

, trading at 120. "Let's say you're 'short' the 110 puts -- you've sold the puts and they're 'naked,' meaning you don't have a position in the underlying security. You've taken in some premium, but it's difficult to quantify the risk if the market tanks.

"If the stock falls, let's say you sell that 110 put. You could lose infinitely. But if you'd bought that put, you can only lose what you spent on it." So

that's

why it's important to discriminate between a buyer, or 'holder,' of a naked put and a seller, or 'writer,' of the put."

In general, Benowitz says, "If you buy a put, you won't get a margin call. You simply have to pay up the next day into your margin account. From the firm's perspective, they love it when retail investors buy puts; then they can quantify their risk. If you spend $5,000 to buy a put, that's all you can lose. If you sell a put, they don't know how much you can lose."

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.