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Options Trading: The put "don't get no respect."

Posted February 11, 2010

Topics: Finance & Investing

Is it un-American to consider puts on an equal footing with calls? In fact, the advantage of using calls and puts is that it enables you to exploit market movement in both directions. Optimism is a great attitude, but only if stock prices are rising.

We American investors tend to think in terms of higher prices coming in the near future. You see this in the pitfall of how people take long positions. It is easy to assume (wrongly) that an entry price is a “zero” starting point, and that prices will move upward from that point forward. Realistically, any price is only the latest entry in a series of price changes, in both directions.

Enter the put.

If you prefer using long options over buying and selling lots of 100 shares, you probably know all about calls. You buy a call, stock prices rise, you sell at a profit. But what happens if the stock price falls? As an owner of a call, your premium value is going to fall and you have to hope that the situation turns around before all of the time value evaporates. Remember, 75% of options expire worthless, so you have to beat the odds to always win with long positions.

Puts expand the horizons of strategic possibilities. For example, not only does the put give you a long play on downward movement (safer compared to shorting stock, and less expensive too). It also opens up a range of more complex strategies. These include simple spreads and straddles as well as using puts to protect long stock positions (insurance puts) and the intriguing synthetic stock position. This involves opening up a position with options that will mirror price movement in the stock.

For example, let’s say you are thinking of buying 100 shares of an $80 stock. That will cost you $8,000. As an alternative you could buy one 80 call and sell one 80 put. This costs little or nothing and could even cash out a small credit if the put’s premium is higher than the call’s. You will be holding an uncovered put that could get exercised. But the combined long call and short put are going to change together in value point for point with changes in the stock, for about the same level of  market risk.

Compare the outcome: If you buy 100 shares and the stock price falls to $74, you lose $600. If you use the synthetic stock strategy, the put could get exercised and you still lose the $600; but you have more choices. First, you can close out the short put to escape exercise. Second, you can roll it forward to avoid exercise while creating more premium income. Third, you can cover the short put by buying a later-expiring long put to offset the risk.

The point is that puts can play a greater role than satisfaction of a gloomy market outlook. There is nothing un-American about using puts. The only un-American approach is to lose money from trading when a different strategy would have led to a profit.