Tuesday, October 9, 2007

Put Buying Strategies, Part 1

Strategy 1: Gaining Leverage

There is value in the leverage gained using the put. With a limited amount of capital, the potential for profits is greater for put buyers than through stock short selling, and with considerably less risk.

Example: Safer than Shorting Stock: A stock currently is valued at $60 per share. If you sell short 100 shares and the stock drops five points, you can close the position and take a profit of $500. However, rather than selling short, you could buy 12 puts at 5, for a total investment of $6,000. A five-point drop in this case would produce a profit of $6,000, a 100 percent gain (assuming no change in time value). So by investing the same amount in puts, you could earn a 100 percent profit, compared to an 8.3 percent profit through short selling.

This example demonstrates the value in leverage, but the risk element for each strategy is not comparable. The short seller faces risks not experienced by the put buyer, and has to put up collateral and pay interest; in comparison, the put buyer has to fight against time. Risking $6,000 by buying puts is highly speculative and, while short selling is risky as well, the two strategies have vastly different attributes. The greater profit potential through leverage in buying puts is accompanied by equally higher risk of loss. However, even without a large sum of capital to speculate with, you can still use leverage to your advantage. This comparative analysis shows the flaw in analyzing two dissimilar strategies. Because the risk attributes are so different for each, it is not accurate to draw conclusions based only on potential returns.

Example: Comparing Apples to Oranges: You buy a LEAPS put for 5 with a striking price of 60 and 18 months until expiration. The stock currently is selling at $60 per share; your option is at the money. Aware of the potential profit or loss in your strategy, your decision to buy puts was preferable over selling short the stock. The luxury of 18 months in the LEAPS put is preferable over remaining exposed to short selling of stock. A drop of five points in the stock's market value would produce a $500 gain with either strategy (assuming no change in time value premium).

The short seller, like the put buyer, has a time problem. The short seller has to place collateral on deposit equal to a part of the borrowed stock's value, and pay interest on the borrowed amount. Thus, the more time the short position is left open, the higher the interest costand the more decline in the stock's value the short seller requires to make a profit. While the put buyer is concerned with diminishing time value, the short seller pays interest, which erodes future profits, if they ever materialize, or which increases losses.

A decline of five points in the preceding example produces an 8.1 percent profit for the short seller and a 100 percent profit for the put buyer. Compare the risks with this yield difference in mind. Short selling risks are unlimited in the sense that a stock's value could rise indefinitely, creating ever-increasing losses. The put buyer's risk is limited to the $500 investment. A drop of $1 per share in the stock's value creates a 1.6 percent profit for the short seller, and a 20 percent profit for the put buyer.

Potential losses can be compared between strategies as one form of risk evaluation. When a short seller's stock rises in value, the loss could be substantial. It combines market losses with continuing interest expense and tied up collateral (creating a lost opportunity). The put buyer's losses can never exceed the premium cost of the put.

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