by Michael Shulman 08/06/08
Buying a Put Option
A put option contract is a contract to "put," or force someone to buy, a stock at a fixed price sometime in the future. A put option contract has a limited duration and expires or the buyer can exercise the contract at any time during the life of the option.
Puts are used by investors going short who do not want to borrow the stock or want more leverage -- a rapidly appreciating put generates a better-percentage return than a traditional short position.
Let's look at Dell again -- you decide to go short through the purchase of put option contracts. It is February; you buy a $40 put contract that expires in November. This put is selling for $3.50.
Seven weeks later, Dell releases the bad news and the stock drops to $30. The put you paid $3.50 for now sells for $12.50. Why? Because an owner of the put, on the day it can be exercised, can buy the stock in the open market for $30 and "put" that stock, or force someone to buy it, for $40, a $10 profit.
The other $2.50 in the put price is called the premium and represents the time value of money. You have a more than 300% profit in seven weeks, and you took on a whole lot less risk by buying the put options than by shorting the shares outright.
Buying LEAPS
LEAPS are both calls and puts that you can hold for a longer time horizon than regular shorter-term options -- up to two and a half years -- which gives them potentially different tax treatment.
LEAPS are more expensive -- the premiums are greater because they are held longer -- but are also less volatile than shorter-term puts. You can buy a LEAP put if the slide in a company or sector is evident but looks like it will take some time to play out.
Selling a Covered Call Option
Investors don't think of this as shorting, but it is. Selling a call option contract gives someone else the right to buy a stock at a fixed price at a fixed date in the future based on a stock you hold in your portfolio.
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