The Limited Life of the Put

If you believe the underlying stock's market value will decline in the near future, you can take one of three actions in the market: sell short on shares of the stock, sell calls, or buy puts. When you buy a put, your desire is that the underlying stock value will fall below the striking price; the more it falls, the higher your profit. Your belief and hope is opposite that of a call buyer. In that respect, many people view call buyers as optimists and put buyers as pessimists.

It is more reasonable when using puts to define yourself as someone who recognizes the cyclical nature of prices in the market, and who believes that a stock is overvalued. Then put buying is sensible for two reasons. First, if you are correct, it may be a profitable decision. Second, buying puts contains much lower risk than short selling stock or call selling.

Your risk is limited to the premium paid for the put. As a put buyer, you face identical risks to those experienced by the call buyer. But when compared to selling short 100 shares of stock, put buyers have far less risk and much less capital requirement. The put buyer does not have to deposit collateral or pay interest on borrowed stock, is not exposed to exercise as a seller would be, and does not face the same risks as the short seller; yet the put buyer can make as much profit. The only disadvantage is the ever-pending expiration date. Time works against the put buyer, and time value premium evaporates with increasing speed as expiration approaches. If the stock's market value declines, but not enough to offset lost time value in the put, you could experience a loss or only break even. The strategy requires price drops adequate to produce a profit.

Compare the various strategies you can employ using shares of stock or options, depending on what you believe will happen in the near-term future to the market value of the underlying stock:

You believe that the market will:
RiseFall
Stock strategyBuy shares (long)Sell shares (short)
Option strategy (long)Buy callsBuy puts
Option strategy (short)Sell putsSell calls

Example

Perfect Timing: You have been watching a stock over the past few months. You believe it is overpriced today, and you expect market value to decline in the near term. Originally, you had planned to buy shares, but now you think the timing is wrong. Instead, you borrow 100 shares from your brokerage firm and sell them short. A few weeks later, the stock has fallen 8 points. You close the position by buying 100 shares. Your profit is $800, less trading costs and interest.


Example

Limiting Risk Exposure: You believe that a particular stock's market value will decline, but you do not want to sell short on the shares, recognizing that the risks and costs are too high. You also do not want to sell a call. That leaves you with a third choice, buying a put. You find a put with several months until expiration, whose premium is 3. If you are right and the stock's market value falls, you could make a profit. But if you are wrong and market value remains the same or rises (or falls, but not enough to produce a profit), your maximum risk exposure is only $300.

As a put buyer, you benefit from a stock's declining market value, and at the same time you avoid the cost and risk associated with short positions. Selling stock short or selling calls exposes you to significant market risks, often for small profit potential.

The limited loss is a positive feature of put buying. However the put—like the call—exists for only a limited amount of time. To profit from the strategy, you need to see adequate downward price movement in the stock to offset time value and to exceed your initial premium cost. So as a put buyer, you trade limited risk for limited life. If you use long-term equity anticipation security (LEAPS) puts, premium costs will be higher, but you also buy more time; so for some speculators, the LEAPS put is a viable alternative to the short-term listed put.

Smart Investor Tip

As a put buyer, you eliminate risks associated with going short, and in exchange, you accept the time restrictions associated with option long positions.

The potential benefit to a particular strategy is only half of the equation. The other half is risk. You need to know exactly how much price movement is needed to break even and to make a profit. Given time until expiration, is it realistic to expect that much price movement? There will be greater risks if your strategy requires a six-point movement in two weeks, and relatively small risks if you need only three points of price movement over two months or, in the case of LEAPS, over many more months.

You can view a LEAPS put in terms of risk in one of two ways. Of course, the extrinsic and time value problems and opportunities remain as they do with all options. But the extended period of time has an offsetting element to remember. First, you pay more for the additional time. Second, your risk is reduced because the added time provides more opportunities for favorable price movement. Thus, potential profits are improved for higher initial option premium cost. For anyone purchasing puts, this trade-off is the ultimate judgment call. You seek bargain prices, but you also seek the most time. So the offset between opportunity and risk is defined by the offset between time and cost.

Example

The Time-versus-Cost Decision: You want to buy a put on Motorola (MOT) in the month of December. You review three different possibilities, those expiring in four months (April), in 13 months (the following January), and in 25 months (January a year later). At the time, Motorola's market value was $20.67 per share. The put values were:
Put Striking Prices
Striking Prices4 Months13 Months25 Months
17.500.300.951.35
200.951.752.30
22.502.353.103.50
254.404.805.00
309.409.659.75
The selection of one put over another should depend on your preferences: in or out of the money, proximity between striking price and current market value of the stock, and, of course, the price of each put. The 17.50 and 20 puts are only slightly out of the money and so the distances between premium value reflect this potential. Extrinsic value is greater, thus the distances between put values based on the proximity issue. But when you study the in-the-money puts (those higher than current market value of $20.67 per share), you can spot some advantageous situations. Extrinsic value again affects the situation; for example, the 22.50 puts are relatively close to current market value, but study the prices of the 30 puts. These are quite far in the money, considering striking price of 30 and current market value of 20.67—more than nine points.

If you were inclined to invest in a long put on this stock and favored in-the-money puts, the 30 is more expensive, but the extrinsic value is very low. If you were to select the 25-month put rather than the 13-month put, the added cost would be only $10, the difference between 9.65 and 9.75. In other words, for only $10, you "buy" an additional 12 months in the put, giving you that extra year of potential. Thus, if Motorola were to decline several points over 25 months, this added cost provides you with much greater potential for profit. The 25 put can be subjected to the same argument, with the added cost only $20, the difference between 4.80 and 5.00.

The point to this comparison is that the farther away from striking price, the smaller the increments in extrinsic value. This gives you the opportunity to extend the put's lifetime for very little added cost.

Put buying is suitable for you only if you understand the risks and are familiar with price history and volatility in the underlying stock, not to mention the other fundamental and technical aspects that make a particular stock a good prospect for your options strategy. Without a doubt, buying puts is a risky strategy, and the smart put buyer knows this from the start.

Example

Calling the Market Correctly: You have $600 available and you believe that the market as a whole is overpriced. You expect it to fall in the near future. So you buy two puts at 3 each. The market does fall as expected; but the underlying stock remains unchanged and the puts begin to lose their time value. At expiration, they are worth only 1.

Your perception of the market was correct: prices fell. But put buyers cannot afford to depend on overall impressions. The strategy lost money because the underlying stock did not behave in the same way as the market in general. The problem with broad market indicators is that such indicators cannot be reliably applied to single stocks. Each stock has its own attributes and reacts differently in changing markets, as well as to its own internal changes—revenues and earnings, capitalization, competitive forces, and the economy, to name a few. Some stocks tend to follow an upward or downward price movement in the larger market, and others do not react to markets as a whole. It is important to study the attributes of the individual stock rather than assuming that overall indicators and index trends are going to apply accurately to a specific stock.

In the preceding example, it appears that the strategy was inappropriate. First, capital was invested in a high-risk strategy. Second, the entire amount was placed into puts on the same stock. By basing a decision on the overall market trend without considering the indicators for the specific company, you lost money. It is likely, too, that you did not understand the degree of price change required to produce a profit. If you do not know how much risk a strategy involves, then it is not an appropriate strategy. More study and analysis is required.

Smart Investor Tip

When it comes to market risk, the unasked question can lead to unexpected losses. Whatever strategy you employ, you need to first explore and understand all of the risks involved.

It is not unusual for investors to concentrate on potential gain without also considering the potential loss, especially in the options market. In the previous example, one reason you lost was a failure to study the individual stock. One aspect not considered was the company's strength in a declining market, its ability to hold its price. This information might have been revealed with more focused analysis and a study of the stock's price history in previous markets. Options traders may lose not because their perception of the market is wrong, but because there was not enough time for their strategy to work—in other words, because they did not fully understand the stock-specific implications and option-specific timing aspects of the decision.

Once you understand the risks and are convinced that you can afford the losses that could occur, you might decide that it is appropriate to buy puts in some circumstances. Remember, though, that the evaluation has to involve not only the option—premium level, time value, and time until expiration—but also the attributes of the underlying stock.

You are aware of the difference between long-term investment and short-term speculation in the preceding example. You have established a base in your portfolio, and you thoroughly understand how the market works. You can afford some minor losses with capital set aside purely for speculation. Buying puts is an appropriate strategy given your belief about the market, particularly since you understand that stocks in your portfolio are likely to fall along with broader market trends. Your ability to afford losses, and the proper selection of stocks on which to buy puts, add up to a greater chance of success.

Example

Losses You Can Afford: You are an experienced investor and you have a well-diversified investment portfolio. You own shares in companies in different market sectors and also own shares in two mutual funds, plus some real estate. You have been investing for several years, fully understand the risks in these markets, and consider yourself a long-term and conservative investor. In selecting stocks, you have always used their potential for long-term price appreciation and a history of stability in earnings as your primary selection criteria. Short-term price movement does not concern you with these longer-term aspects in mind. Outside of this portfolio, you have funds available that you use for occasional speculation. You believe the market will fall in the short-term, including the value of shares of stock that you own. You buy puts with this in mind. Your theory: Any short-term losses in your permanent portfolio will be offset by gains in your put speculation. And if you are wrong, you can afford the losses.

By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

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