Now let's imagine that you
have a strong feeling a
particular stock is about to
move lower.
Before puts came into
existence, your only
alternative was to short
sell the stock. Short
selling stock is an
incredibly risky strategy.
Should the stock move
higher, your loss would be
theoretically unlimited.
Rather than opening yourself
to enormous risk, you could
buy puts (the right to sell
the stock at a fixed price).
Example
Let's look at an example
option. Cisco (CSCO) is
trading at $16.07. The
JUN 15 puts
are trading for $0.55. For
$55 you could buy one
JUN 15 put
(100 shares x $0.55). Since
each contract controls 100
shares, you now have the
right to sell 100 shares at
$15 per share. If the stock
stays at or above $15.00
before the option expires,
the most you could lose is
your initial investment of
$55.
On the other hand, if the
stock falls to $11 at
expiration, the JUN
15 put will be
worth $4 (strike price: $15
– current stock price: $11).
At this point, your put is
worth $400 ($4 x 100
shares). After subtracting
the cost of the premium paid
and before commissions your
gain is $345, a 627% gain on
your investment.
To achieve the same
percentage gain on a typical
stock trade, a $100 stock
would have to increase in
value to nearly $800 per
share. Needless to say, that
doesn't happen every day.
 
To better see the leverage
of options, let's look again
at the returns on a
percentage basis.
|
Purchase $ |
Sale $ |
Profit (L) |
%Gain (L) |
Stock Price |
$15.90 |
$11.00 |
$4.90 |
30.8% |
Short 100 Shares |
$1,590.00 |
$1,100.00 |
$490.00 |
30.8% |
1 Jun 15 Put |
$55.00 |
$490.00 |
$430.00 |
716.7% |
Now, let's see what happens
if the stock unexpectedly
rises.
|
Purchase $ |
Sale $ |
Profit (L) |
%Gain (L) |
Stock Price |
$15.90 |
$20.00 |
($4.10) |
(25.8%) |
Short 100 Shares |
$1,590.00 |
$2,000.00 |
($410.00) |
(25.8%) |
1 Jun 15 Put |
$55.00 |
$0.00 |
($55.00) |
(100%) |
If you sold the stock short
at $15, thinking it would go
down, and it rose quickly to
$20, you can buy the stock
and limit your losses. In
this case, you would lose
$500 (100 shares x $5
share). It's also easy to
see that this could get
worse. The stock could
continue climbing
indefinitely. Had you
purchased the puts rather
than sold the stock short,
your loss would be limited
to the price of the puts-in
this case $55.
Risks
With both puts and
calls, the risks fall
into the same categories,
time and market direction.
To make a profit, the buyer
of these options has to be
right about the price
movement of the stock and
the time frame in which it
will occur. If the stock
doesn't make its move before
the options expire, they
will expire worthless. While
a stockholder is concerned
with market direction, the
timeframe isn't as critical
because stock doesn't have
an expiration date. You can
hold a stock for decades.
You can't do the same with
options. With the exception
of LEAPS (long-term option
contracts), most options
expire in a matter of
months. |