a,,pter 15: Put Option Basics 255
option market, it was often stated that the reason for this relationship was that the
demand for calls was larger than the demand for puts. This may have been partially
true, but certainly it is no longer true in the listed option targets, where alarge sup
ply of both listed puts and calls is available through the OCC. Arbitrageurs again
serve auseful function in increasing supply and demand where it might not other
wise exist. The second fact concerning the relationship of puts and calls is that aput
option will lose its time value premium much more quickly in-the-money than acall
option will (and, conversely, aput option will generally hold out-of-the-money time
value premium better than acall option will). Again, the conversion and reversal
processes play alarge role in this price action phenomenon of puts and calls. Both of
these facts have to do with the carrying costs involved in the conversion.
In the chapter on Arbitrage, exact details of conversions and reversals will be
spelled out, with specific reasons why these procedures affect the relationship of put
and call prices as stated above. However, at this time, it is sufficient for the reader to
understand that there is an arbitrage process that is quite widely practiced that will,
in fact, make true the foregoing relationships between puts and calls.

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Put Option Buying
The purchase of aput option provides leverage in the case of adownward move by
the underlying stock. In this manner, it is an alternative to the short sale of stock,
much as the purchase of acall option is aleveraged alternative to the purchase of
stock.
PUT BUYING VERSUS SHORT SALE
In the simplest case, when an investor expects astock to decline in price, he may
either short the underlying stock or buy aput option on the stock. Suppose that XYZ
is at 50 and that an XYZ July 50 put option is trading at 5. If the underlying stock
declines substantially, the buyer of the put could make profits considerably in excess
of his initial investment. However, if the underlying stock rises in price, the put buyer
has limited risk; he can lose only the amount of money that he originally paid for the
put option. In this example, the most that the put buyer could lose would be 5 points,
which is equal to his entire initial investment. Table 16-1 and Figure 16-1 depict the
results, at expiration, of this simple purchase of the put option.
The put buyer has limited profit potential, since astock can never drop in price
below zero dollars per share. However, his potential profits can be huge, percent
agewise. His loss, which normally would occur if the stock rises in price, is limited to
the amount of his initial investment. The simplest use of aput purchase is for specu
lative purposes when expecting aprice decline in the underlying stock.
These results for the profit or loss of the put option purchases can be compared
to asimilar short sale of XYZ at 50 in order to observe the benefits of leverage and
limited risk that the put option buyer achieves. In order to sell short 100 XYZ at 50,
assume that the trader would have to use $2,500 in margin. Several points can be ver-
256

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258 Part Ill: Put Option Strategies
chase can achieve. If the underlying stock remains relatively unchanged, the short
seller would do better because he does not risk losing his entire investment in alim
ited amount of time if the underlying stock changes only slightly in price. However,
if the underlying stock should rise dramatically, the short seller can actually lose more
than his initial investment. The short sale of stock has theoretically unlimited risk.
Such is not true of the put option purchase, whereby the risk is limited to the amount
of the initial investment. One other point should be made when comparing the pur
chase of aput and the short sale of stock: The short seller of stock is obligated to pay
the dividends on the stock, but the put option holder has no such obligation. This is
an additional advantage to the holder of the put.
TABLE 16-2.
Results of selling short.
XYZ Price at Put Option
Expiration Short Sale Purchase
20 + $3,000 (+ 120%) +$2,500 (+ 500%)
30 + 2,000 (+ 80%) + 1,500 (+ 300%)
40 + 1,000 (+ 40%) + 500 (+ 100%)
45 + 500(+ 20%) 0( 0%)
48 + 200(+ 80%) 300 (- 60%)
50 0( 0%) 500 (- 100%)
60 - 1,000 (- 40%) 500 (- 100%)
75 - 2,500 (- 100%) 500 (- 100%)
100 - 5,000 (- 200%) 500 (- 100%)
SELECTING WHICH PUT TO BUY
Many of the same types of analyses that the call buyer goes through in deciding which
call to buy can be used by the prospective put buyer as well. First, when approach
ing put buying as aspeculative strategy, one should not place more than 15% of his
risk capital in the strategy. Some investors participate in put buying to add some
amount of downside protection to their basically bullishly-oriented common stock
portfolios. More is said in Chapter 17 about buying puts on stocks that one actually
owns.
The out-ofthe-nwney put offers both higher reward potentials and higher risk
potentials than does the in-the-nwney put. If the underlying stock drops substantial-

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G,pter 16: Put Option Buying 259
ly, the percentage returns from having purchased acheaper, out-of-the-money put
will be greater. However, should the underlying stock decline only moderately in
price, the in-the-rrwney put will often prove to be the better choice. In fact, since aput option tends to lose its time value premium quickly as it becomes an in-the
money option, there is an even greater advantage to the purchase of the in-the
money put.
Example: XYZ is at 49 and the following prices exist:
XYZ, 49;
XYZ July 45 put, l; and
XYZ July 50 put, 3.
If the underlying stock were to drop to 40 by expiration, the July 45 put would be
worth 5 points, a 400% profit. The July 50 put would be worth 10 points, a 233%
profit over its initial purchase price of 3. Thus, in asubstantial downward move, the
out-of-the-money put purchase provides higher reward potential. However, if the
underlying stock drops only moderately, say to t:15, the purchaser of the July 45 put
would lose his entire investment, since the put would be worthless at expiration. The
purchaser of the in-the-money July 50 put would have a 2-point profit with XYZ at
45 at expiration.
The preceding analysis is based on holding the put until expiration. For the
option buyer, this is generally an erroneous form of analysis, because the buyer
generally tends to liquidate his option purchase in advance of expiration. When
considering what happens to the put option in advance of expiration, it is helpful to
remember that an in-the-money put tends to lose its time premium rather quickly.
In the example above, the July 45 put is completely composed of time value pre
mium. If the underlying stock begins to drop below 45, the price of the put will not
increase as rapidly as would the price of acall that is going into-the-money.
Example: If XYZ fell by 5 points to 44, definitely amove in the put buyer'sfavor, he
may fmd that the July 45 put has increased in value only to 2 or 2½ points. This is
somewhat disappointing because, with call options, one would expect to do signifi
cantly better on a 5-point stock movement in his favor. Thus, when purchasing put
options for speculation, it is generally best to concentrate on in-the-rrwney puts unless
avery substantial decline in the price of the underlying stock is anticipated.
Once the put option is in-the-money, the time value premium will decrease
even in the longer-term series. Since this time premium is small in all series, the put

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260 Part Ill: Put Option Strategies
buyer can often purchase alonger-term option for very little extra money, thus gain
ing more time to work with. Call option buyers are generally forced to avoid the
longer-term series because the extra cost is not worth the risk involved, especially in
atrading situation. However, the put buyer does not necessarily have this disadvan
tage. If he can purchase the longer-term put for nearly the same price as the near
term put, he should do so in case the underlying stock takes longer to drop than he
had originally anticipated it would.
It is not uncommon to see such prices as the following:
XYZ common, 46:
XYZ April 50 put, 4;
XYZ July 50 put, 4½; and
XYZ October 50 put, 5.
None of these three puts have much time value premium in their prices. Thus, the
buyer might be willing to spend the extra 1 point and buy the longest-term put. If the
underlying stock should drop in price immediately, he will profit, but not as much as
if he had bought one of the less expensive puts. However, should the underlying stock
rise in price, he will own the longest-term put and will therefore suffer less of aloss,
percentagewise. If the underlying stock rises in price, some amount of time value
premium will come back into the various puts, and the longest-term put will have the
largest amount of time premium. For example, if the stock rises back to 50, the fol
lowing prices might exist:
XYZ common, 50;
XYZ April 50 put, l;
XYZ July 50 put, 2½; and
XYZ October 50 put, 3½.
The purchase of the longer-term October 50 put would have suffered the least loss,
percentagewise, in this event. Consequently, when one is purchasing an in-the
money put, he may often want to consider buying the longest-term put if the time
value premium is small when compared to the time premium in the nearer-term
puts.
In Chapter 3, the delta of an option was described as the amount by which one
might expect the option will increase or decrease in price if the underlying stock
moves by afixed amount (generally considered to be one point, for simplicity). Thus,
if XYZ is at 49 and acall option is priced at 3 with adelta of ½, one would expect the
call to sell for 3½ with XYZ at 50 and to sell at 2¼ with XYZ at 48. In reality, the delta

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O.,ter 16: Put Option Buying 261
changes even on afractional move in the underlying stock, but one generally assumes
that it will hold true for a 1-point move. Obviously, put options have deltas as well. The
delta of aput is anegative number, reflecting the fact that the put price and the stock
price are inversely related. As an approximation, one could say that the delta of the
ctill option minus the delta of the put option with the same terms is equal to 1. That is,
Delta of put = Delta of call - 1.
This is an approximation and is accurate unless the put is deeply in-the-money. It has
already been pointed out that the time value premium behavior of puts and calls is
different, so it is inaccurate to assume that this formula holds true exactly for all
cases.
The delta of aput ranges between Oand minus 1. If a July 50 put has adelta of
-½, and the underlying stock rises by 1 point, the put will lose ½ point. The delta of
adeeply out-of-the-money put is close to zero. The put'sdelta would decrease slow
ly at first as the stock declined in value, then would begin to decrease much more
rapidly as the stock fell through the striking price, and would reach avalue of minus
1 (the minimum) as the stock fell only moderately below the striking price. This is
reflective of the fact that an out-of-the-money put tends to hold time premium quite
well and an in-the-money put comes to parity rather quickly.
RANKING PROSPECTIVE PUT PURCHASES
In Chapter 3, amethod of ranking prospective call purchases was developed that
encompassed certain factors, such as the volatility of the underlying stock and the
expected holding period of the purchased option. The same sort of analysis should be
applied to put option purchases.
The steps are summarized below. The reader may refer to the section titled
"Advanced Selection Criteria" in Chapter 3 for amore detailed description of why
this method of ranking is superior.
1. Assume that each underlying stock can decrease in price in accordance with its
volatility over afixed holding period (30, 60, or 90 days).
2. Estimate the put option prices after the decrease.
3. Rank all potential put purchases by the highest reward opportunity for aggressive
purchases.
4. Estimate how much would be lost if the underlying stock instead rose in accor
dance with its volatility, and rank all potential put purchases by best risk/reward
ratio for amore conservative list of put purchases.

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262 Part Ill: Put Option Strategies
As was stated earlier, it is necessary to have acomputer to make an accurate analysis
of all listed options. The average customer is forced to obtain such data from abro
kerage firm or data service. He should be sure that the list he is using conforms to
the above-mentioned criteria. If the data service is ranking option purchases by how
well the puts would do if each underlying stock fell by afixed percentage (such as 5%
or 10%), the list should be rejected because it is not incorporating the volatility of the
underlying stock into its analysis. Also, if the list is based on holding the put purchase
until expiration, the list should be rejected as well, because this is not arealistic
assumption. There are enough reliable and sophisticated data services that one
should not have to work with inferior analyses in today'soption market.
For those readers who are more mathematically advanced and have the com
puter capability to construct their own analyses, the details of implementing an analy
sis similar to the one described above are presented in Chapter 28, Mathematical
Applications. An application of put purchases, combined with fixed-income securi
ties, is described in Chapter 26, Buying Options and Treasury Bills.
FOLLOW-UP ACTION
The put buyer can take advantage of strategies that are very similar to those the call
buyer uses for follow-up action, either to lock in profits or to attempt to improve alosing situation. Before discussing these specific strategies, it should be stated again
that it is rarely to the option buyer'sbenefit to exercise the option in order to liqui
date. This precludes, of course, those situations in which the call buyer actually wants
to own the stock or the put buyer actually wants to sell the stock. If, however, the
option holder is merely looking to liquidate his position, the cost of stock commis
sions makes exercising aprohibitive move. This is true even ifhe has to accept aprice
that is aslight discount from parity when he sells his option.
LOCKING IN PROFITS
The reader may recall that there were four strategies (perhaps "tactics" is abetter
word) for the call buyer with an unrealized profit. These same four tactics can be
used with only slight variations by the put option buyer. Additionally, afifth strategy
can be employed when astock has both listed puts and calls.
After an underlying stock has moved down and the put buyer has arelatively
substantial unrealized gain, he might consider taking one of the following actions:
1. Sell the put and liquidate the position for aprofit.
2. Do nothing and continue to hold the put.

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O.,,er 16: Put Option Buying 263
3, Sell the in-the-money long put and use part of the proceeds to purchase out-of
the-money puts.
4. Create aspread by selling an out-of-the-money put against the one he currently
holds.
These are the same four tactics that were discussed earlier with respect to call buy
ing. In the fifth tactic, the holder of alisted put who has an unrealized profit might
consider buying alisted call to protect his position.
Example: Aspeculator originally purchased an XYZ October 50 put for 2 points when
the stock was 52. If the stock has now fallen to 45, the put might be worth 6 points,
representing an unrealized gain of 4 points and placing the put buyer in aposition to
implement one of these five tactics. After some time has passed, with the stock at 45,
an at-the-money October 45 put might be selling for 2 points. Table 16-3 summarizes
the situation. If the trader merely liquidates his position by selling out the October 50
put, he would realize aprofit of 4 points. Since he is terminating the position, he can
make neither more nor less than 4 points. This is the most conservative of the tactics,
allowing no additional room for appreciation, but also eliminating any chance of los
ing the accumulated profits.
TABLE 16-3.
Background table for profit alternatives.
Original Trade Current Prices
XYZ common: 52 XYZ common: 45
Bought XYZ October 50 put at 2 XYZ October 50 put: 6
XYZ October 45 put: 2
If the trader does nothing, merely continuing to hold the October 50 put, he is
taking an aggressive action. If the stock should reverse and rise back above 50 by
expiration, he would lose everything. However, if the stock continues to fall, he could
build up substantially larger profits. This is the only tactic that could eventually result
in aloss at expiration.
These two simple strategies - liquidating or doing nothing are the easiest
alternatives. The remaining strategies allow one to attempt to achieve abalance
between retaining built-up profits and generating even more profits. The third tactic
that the speculator could use would be to sell the put that he is currently holding and

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264 Part Ill: Put Option Strategies
use some of the proceeds to purchase the October 45 put. The general idea in this
tactic is to pull one'sinitial investment out of the market and then to increase the
number of option contracts held by buying the out-of-the-money option.
Example: The trader would receive 6 points from the sale of the October 50 put. He
should take 2 points of this amount and put it back into his pocket, thus covering his
initial investment. Then he could buy 2 October 45 puts at 2 points each with the
remaining portion of the proceeds from the sale. He has no risk at expiration with this
strategy, since he has recovered his initial investment. Moreover, if the underlying
stock should continue to fall rapidly, he could profit handsomely because he has
increased the number of put contracts that he holds.
The fourth choice that the put holder has is to create aspread by selling the
October 45 put against the October 50 that he currently holds. This would create abear spread, technically. This type of spread is described in more detail later. For the
time being, it is sufficient to understand what happens to the trader'srisks and
rewards by creating this spread. The sale of the October 45 put brings in 2 points,
which covers the initial 2-point purchase cost of the October 50 put. Thus, his "cost"
for this spread is nothing; he has no risk, except for commissions. If the underlying
stock should rise above 50 by expiration, all the puts would expire worthless. (Aput
expires worthless when the underlying stock is above the striking price at expiration.)
This would represent the worst case; he would recover nothing from the spread. If
the stock should be below 45 at expiration, he would realize the maximum potential
of the spread, which is 5 points. That is, no matter how far XYZ is below 45 at expi
ration, the October 50 put will be worth 5 points more than the October 45 put, and
the spread could thus be liquidated for 5 points. His maximum profit potential in the
spread situation is 5 points. This tactic would be the best one if the underlying stock
stabilized near 45 until expiration.
To analyze the fifth strategy that the put holder could use, it is necessary to
introduce acall option into the picture.
Example: With XYZ at 45, there is an October 45 call selling for 3 points. The put
holder could buy this call in order to limit his risk and still retain the potential for
large future profits. If the trader buys the call, he will have the following position:
Long l October 50 put Cb' dt 5 . tl Ob 5 all - om me cos : porn s Long cto er 4 c
The total combined cost of this put and call combination is 5 points - 2 points were
originally paid for the put, and now 3 points have been paid for the call. No matter
where the underlying stock is at expiration, this combination will be worth at least 5

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Gapter 16: Put Option Buying 265
points. For example, if XYZ is at 46 at expiration, the put will be worth 4 and the call
worth l; or if XYZ is at 48, the put will be worth 2 and the call worth 3. If the stock
is above 50 or below 45 at expiration, the combination will be worth more than 5
points. Thus, the trader has no risk in this combination, since he has paid 5 points for
it and will be able to sell it for at least 5 points at expiration. In fact, if the underly
ing stock continues to drop, the put will become more valuable and he could build
up substantial profits. Moreover, if the underlying stock should reverse direction and
climb substantially, he could still profit, because the call will then become valuable.
This tactic is the best one to use if the underlying stock does not stabilize near 45,
but instead makes arelatively dramatic move either up or down by expiration. The
strategy of simultaneously owning both aput and acall is discussed in much greater
detail in Chapter 23. It is introduced here merely for the purposes of the put buyer
wanting to obtain protection of his unrealized profits.
Each of these five strategies may work out to be the best one under adifferent
set of circumstances. The ultimate result of each tactic is dependent on the direction
that XYZ moves in the future. As was the case with call options, the spread tactic
never turns out to be the worst tactic, although it is the best one only if the underly
ing stock stabilizes. Tables 16-4 and 16-5 summarize the results the speculator could
expect from invoking each of these five tactics. The tactics are:
1. Liquidate - sell the long put for aprofit and do not reinvest.
2. Do nothing - continue to hold the long put.
3. "Roll down" - sell the long put, pocket the initial investment, and invest the
remaining proceeds in out-of-the-money puts at alower strike.
4. "Spread" - create aspread by selling the out-of-the-money put against the put
already held.
5. "Combine" create acombination by buying acall at alower strike while con
tinuing to hold the put.
TABLE 16-4.
Comparison of the five tactics.
By expiration, if XYZ ...
Continues to fall dramatically
Falls moderately further
Remains relatively unchanged
Rises moderately
Rises substantially
the best strategy was ...
"Roll down"
Do nothing
Spread
Liquidate
Combine
and the worst
strategy was ...
Liquidate
Combine
Combine or "roll down"
"Roll down" or do nothing
Do nothing

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266 Part Ill: Put Option Strategies
TABLE 16-5.
Results of adopting each of the five tactics.
XYZ Price at "Roll Down" Do-Nothing Spread Liquidate Combine
Expiration Profit Profit Profit Profit Profit
30 + $3,000 (8) +$1,800 +$500 +$400 (W) +$1,500
35 + 2,000 (8) + 1,300 + 500 + 400 (W) + 1,000
41 + 800 (8) + 700 + 500 + 400 (W) + 400
42 + 600 (8) + 600 (8) + 500 + 400 + 300 (W)
43 + 400 + 500 (8) + 500 (8) + 400 + 200 (W)
45 0(W) + 300 + 500 (8) + 400 0(W)
46 0(W) + 200 + 400 (8) + 400 (8) O(W)
48 0(W) 0(W) + 200 + 400 (8) 0(W)
50 0 200 (W) 0 + 400 (8) 0
54 0 200 (W) 0 + 400 (8) + 400 (8)
60 0 200 (W) 0 + 400 + 1,000 (8)
Note that each tactic is the best one under one of the scenarios, but that the spread
tactic is never the worst of the five. The actual results of each tactic, using the figures
from the example above, are depicted in Table 16-5, where Bdenotes best tactic and
Wdenotes worst one.
All the strategies are profitable if the underlying stock continues to fall dramat
ically, although the "roll down," "do nothing," and combinations work out best,
because they continue to accrue profits if the stock continues to fall. If the underly
ing stock rises instead, only the combination outdistances the simplest tactic of all,
liquidation.
If the underlying stock stabilizes, the "do-nothing" and "spread" tactics work out
best. It would generally appear that the combination tactic or the "roll-down" tactic
would be the most attractive, since neither one has any risk and both could generate
large profits if the stock moved substantially. The advantage for the spread was sub
stantial in call options, but in the case of puts, the premium received for the out-of
the-money put is not as large, and therefore the spread strategy loses some of its
attractiveness. Finally, any of these tactics could be applied partially; for example, one
could sell out half of aprofitable long position in order to take some profits, and con
tinue to hold the remainder.

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Cl,opter 16:PutOptionBuying
LOSS-LIMITING ACTIONS
267
The foregoing discussion concentrated on how the put holder could retain or
increase his profit. However, it is often the case in option buying that the holder of
the option is faced with an unrealized loss. The put holder may also have several
choices of action to take in this case. His first, and simplest, course of action would
be to sell the put and take his loss. Although this is advisable in certain cases, espe
cially when the underlying stock seems to have assumed adistinctly bullish stance, it
is not always the wisest thing to do. The put holder who has aloss may also consider
either "rolling up" to create abearish spread or entering into acalendar spread.
Either of these actions could help him recover part or all of his loss.
THE "ROLLING-UP" STRATEGY
The reader may recall that asimilar action to "rolling up," termed "rolling down," was
available for call options held at aloss and was described in Chapter 3. The put buyer
who owns aput at aloss may be able to create aspread that allows him to break even
at amore favorable price at expiration. Such action will inevitably limit his profit
potential, but is generally useful in recovering something from aput that might oth
erwise expire totally worthless.
Example: An investor initially purchases an XYZ October 45 put for 3 points when
the underlying stock is at 45. However, the stock rises to 48 at alater date and the
put that was originally bought for 3 points is now selling for 1 ¼ points. It is not
unusual, by the way, for aput to retain this much of its value even though the stock
has moved up and some amount of time has passed, since out-of-the-money puts
tend to hold time value premium rather well. With XYZ at 48, an October 50 put
might be selling for 3 points. The put holder could create aposition designed to per
mit recovery of some of his losses by selling two of the puts that he is long - October
45's - and simultaneously buying one October 50 put. The net cost for this transac
tion would be only commissions, since he receives $300 from selling two puts at 1 ¼
each, which completely covers the $300 cost of buying the October 50 put. The
transactions are summarized in Table 16-6.
By selling 2 of the October 45 puts, the investor is now short an October 45 put.
Since he also purchased an October 50 put, he has aspread ( technically, abear
spread). He has spent no additional money, except commissions, to set up this spread,
since the sale of the October 45'scovered the purchase of the October 50 put. This
strategy is most attractive when the debit involved to create the spread is small. In
this example, the debit is zero.

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268
TABLE 16-6.
Summary of rolling-up transactions.
Original trade:
Later:
Net position:
Buy 1 October 45 put for 3
with XYZ at 45
With XYZ at 48, sell 2
October 45'sfor 11/2 each
and buy l October 50 put for 3
Long 1 October 50 put
Short 1 October 45 put
Part Ill: Put Option Strategies
$300 debit
$300 credit
$300 debit
$300 debit
The effect of creating this spread is that the investor has not increased his risk
at all, but has raised the break-even point for his position. That is, if XYZ merely falls
asmall distance, he will be able to get out even. Without the effect of creating the
spread, the put holder would need XYZ to fall back to 42 at expiration in order for
him to break even, since he originally paid 3 points for the October 45 put. His orig
inal risk was $300. IfXYZ continues to rise in price and the puts in the spread expire
worthless, the net loss will still be only $300 plus additional commissions. Admittedly,
the commissions for the spread will increase the loss slightly, but they are small in
comparison to the debit of the position ($300). On the other hand, if the stock should
fall back only slightly, to 47 by expiration, the spread will break even. At expiration,
with XYZ at 47, the in-the-money October 50 put will be worth 3 points and the out
of-the-money October 45 put will expire worthless. Thus, the investor will recover his
$300 cost, except for commissions, with XYZ at 47 at expiration. His break-even point
is raised from 42 to 47, asubstantial improvement of his chances for recovery.
The implementation of this spread strategy reduces the profit potential of the
position, however. The maximum potential of the spread is 2 points. If XYZ is any
where below 45 at expiration, the spread will be worth 5 points, since the October 50
put will sell for 5 points more than the October 45 put. The investor has limited his
potential profit to 2 points - the 5-point maximum width of the spread, less the 3
points that he paid to get into the position. He can no longer gain substantially on alarge drop in price by the underlying stock. This is normally of little concern to the
put holder faced with an unrealized loss and the potential for atotal loss. He gener
ally would be appreciative of getting out even or of making asmall profit. The cre
ation of the spread accomplishes this objective for him.
It should also be pointed out that he does not incur the maximum loss of his
entire debit plus commissions, unless XYZ closes above 50 at expiration. If XYZ is

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O,apter 16: Put Option Buying 269
anywhere below 50, the October 50 will have some value and the investor will be able
to recover something from the position. This is distinctly different from the original
put holding of the October 45, whereby the maximum loss would be incurred unless
the stock were below 45 at expiration. Thus, the introduction of the spread also
reduces the chances of having to realize the maximum loss.
In summary, the put holder faced with an unrealized loss may be able to create
aspread by selling twice the number of puts that he is currently long and simultane
ously buying the put at the next higher strike. This action should be used only if the
spread can be transacted at asmall debit or, preferably, at even money (zero debit).
The spread position offers amuch better chance of breaking even and also reduces
the possibility of having to realize the maximum loss in the position. However, the
introduction of these loss-limiting measures reduces the maximum potential of the
position if the underlying stock should subsequently decline in price by asignificant
amount. Using this spread strategy for puts would require amargin account, just as
calls do.
THE CALENDAR SPREAD STRATEGY
Another strategy is sometimes available to the put holder who has an unrealized loss.
If the put that he is holding has an intermediate-term or long-term expiration date,
he might be able to create acalendar spread by selling the near-term put against the
put that he currently holds.
Example: An investor bought an XYZ October 45 put for 3 points when the stock was
at 45. The stock rises to 48, moving in the wrong direction for the put buyer, and his
put falls in value to 1 ½. He might, at that time, consider selling the near-term July
45 put for 1 point. The ideal situation would be for the July 45 put to expire worth
less, reducing the cost of his long put by 1 point. Then, if the underlying stock
declined below 45, he could profit after July expiration.
The major drawback to this strategy is that little or no profit will be made - in
fact, aloss is quite possible - if the underlying stock falls back to 45 or below before
the near-term July option expires. Puts display different qualities in their time value
premiums than calls do, as has been noted before. With the stock at 45, the differ
ential between the July 45 put and the October 45 put might not widen much at all.
This would mean that the spread has not gained anything, and the spreader has aloss
equal to his commissions plus the initial unrealized loss. In the example above, ifXYZ
dropped quickly back to 45, the July 45 might be worth 1 ½ and the October worth
2½. At this point, the spreader would have aloss on both sides of his spread: He sold
the July 45 put for 1 and it is now 1 ½; he bought the October 45 for 3 and it is now

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270 Part Ill: Put Option Strategies
2½; plus he has spent two commissions to date and would have to spend two more
to liquidate the position.
At this point, the strategist may decide to do nothing and take his chances that
the stock will subsequently rally so that the July 45 put will expire worthless.
However, if the stock continues to decline below 45, the spread will most certainly
become more of aloss as both puts come closer to parity.
This type of spread strategy is not as attractive as the "rolling-up" strategy. In
the "rolling-up" strategy, one is not subjected to aloss if the stock declines after the
spread is established, although he does limit his profits. The fact that the calendar
spread strategy can lead to aloss even if the stock declines makes it aless desirable
alternative.
EQUIVALENT POSITIONS
Before considering other put-oriented strategies, the reader should understand the
definition of an equivalent position. Two strategies, or positions, are equivalent when
they have the same profit potential. They may have different collateral or investment
requirements, but they have similar profit potentials. Many of the call-oriented
strategies that were discussed in Part II of the book have an equivalent put strategy.
One such case has already been described: The "protected short sale," or shorting the
common stock and buying acall, is equivalent to the purchase of aput. That is, both
have alimited risk above the striking price of the option and relatively large profit
potential to the downside. An easy way to tell if two strategies are equivalent is to see
if their profit graphs have the same shape. The put purchase and the "protected short
sale" have profit graphs with exactly the same shape (Figures 16-1 and 4-1, respec
tively). As more put strategies are discussed, it will always be mentioned if the put
strategy is equivalent to apreviously described call strategy. This may help to clarify
the put strategies, which understandably may seem complex to the reader who is not
familiar with put options.

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Put Buying in Conjunction
with Com.m.on Stock
Ownership
Another useful feature of put options, in addition to their speculative leverage in adownward move by the underlying stock, is that the put purchase can be used to limit
downside loss in astock that is owned. When one simultaneously owns both the com
mon stock and aput on that same stock, he has aposition with limited downside risk
during the life of the put. This position is also called asynthetic long call, because the
profit graph is the same shape as along call's.
Example: An investor owns XYZ stock, which is at 52, and purchases an XYZ October
50 put for 2. The put gives him the right to sell XYZ at 50, so the most that the stock
holder can lose on his stock is 2 points. Since he pays 2 points for the put protection, his
maximum potential loss until October expiration is 4 points, no matter how far XYZ
might decline up until that time. If, on the other hand, the price of the stock should
move up by October, the investor would realize any gain in the stock, less the 2 points
that he paid for the put protection. The put functions much like an insurance policy with
afinite life. Table 17-1 and Figure 17-1 depict the results at October expiration for this
position: buying the October 50 put for 2 points to protect aholding in XYZ common
stock, which is selling at 52. The dashed line on the graph represents the profit poten
tial of the common stock ownership by itself. Notice that if the stock were below 48 in
October, the common stock owner would have been better off buying the put. However,
with XYZ above 48 at expiration, the put purchase was aburden that cost asmall por
tion of potential profits. This strategy, however, is not necessarily geared to maximizing
211

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272 Part Ill: Put Option Strategies
TABLE 17-1.
Results at expiration on aprotected stock holding.
XYZ Price at Stock Put
Expiration Profit Profit
30 -$2,200 +$1,800
40 - 1,200 + 800
50 200 200
54 + 200 200
60 + 800 200
70 + 1,800 200
80 + 2,800 200
FIGURE 17-1.
long common stock and long put.
C:
0
e ·5.
Xw
1i'i $0 Cf)
Cf)
0 ..Jc5
e
0.
-$400
,
, , ,
Long ,'
Stock ,,
,, ,,
, , ,
48 50 ,'52
, ,, ,
,, ,
,
, ,, ,
, , ,,
Stock Price at Expiration
,, ,,
,, ,,
, ,
Total
Profit
-$ 400
400
400
0
+ 600
+ 1,600
+ 2,600
one'sprofit potential on the common stock, but rather provides the stock owner with
protection, eliminating the possibility of any devastating loss on the stock holding during
the life of the put. In all the put buying strategies discussed in this chapter and Chapter
18, the put must be paid for in full. That is the only increase in investment.
Although any common stockholder may use this strategy, two general classes of
stock owners find it particularly attractive: First, the long-term holder of the stock
who is not considering selling the stock may utilize the put protection to limit losses
over ashort-term horizon. Second, the buyer of common stock who wants some
"insurance" in case he is wrong may also find the put protection attractive.

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Cl,apter 17: Put Buying in Conjunction with Common Stock Ownership 273
The long-term holder who strongly feels that his stock will drop should proba
bly sell that stock. However, his cost basis may make the capital gains tax on the sale
prohibitive. He also may not be entirely sure that the stock will decline - and may
want to continue to hold the stock in case it does go up. In either case, the purchase
of aput will limit the stockholder'sdownside risk while still allowing room for upside
appreciation. Alarge number of individual and institutional investors have holdings
that they might find difficult to sell for one reason or another. The purchase of alow
cost put can often reduce the negative effects of abear market on their holdings.
The second general class of put buyers for protection includes the investor who
is establishing aposition in the stock. He might want to buy aput at the same time
that he buys the stock, thereby creating aposition with profitability as depicted in the
previous profit graph. He immediately starts out with aposition that has limited
downside risk with large potential profits if the stock moves up. In this way, he can
feel free to hold the stock during the life of the put without worrying about when to
sell it if it should experience atemporary setback. Some fairly aggressive stock traders
use this technique because it eliminates the necessity of having to place astop loss
order on the stock. It is often frustrating to see astock fall and touch off one'sstop
loss limit order, only to subsequently rise in price.' The stock owner who has aput for
protection need not overreact to adownward move. He can afford to sit back and
wait during the life of the put, since he has built-in protection.
WHICH PUT TO BUY
The selection of which put the stock owner purchases will determine how much of
his profit potential he is giving up and how much risk he is limiting. An out-of-the
money put will cost very little. Therefore, it will be less of ahindrance on profit
potential if the underlying stock rises in price. Unfortunately, the put'sprotective fea
ture is small until the stock falls to the striking price of the put. Therefore, the pur
chase of the out-ofthe-rrwney put will not provide as much downside protection as
an at- or in-the-money put would. The purchase of adeeply out-of-the-money put as
protection is more like "disaster insurance": It will prevent astock owner from expe
riencing adisaster in terms of adownside loss during the life of the put, but will not
provide much protection in the case of alimited stock decline.
Example: XYZ is at 40 and the October 35 put is selling for ½. The purchase of this
put as protection for the common stock would not reduce upside potential much at
all, only by ½ point. However, the stock owner could lose 5½ points if XYZ fell to 35
or below. That is his maximum possible loss, for if XYZ were below 35 at October expi
ration, he could exercise his put to sell the stock at 35, losing 5 points on the stock, and
he would have paid ½ point for the put, bringing his total loss to 5½ points.

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274 Part Ill: Put Option Strategies
At the opposite end of the spectrum, the stock owner might buy an in-the
money put as protection. This would quite severely limit his profit potential, since the
underlying stock would have to rise above the strike and more for him to make aprofit. However, the in-the-money put provides vast quantities of downside protec
tion, limiting his loss to avery small amount.
Example: XYZ is again at 40 and there is an October 45 put selling for 5½. The stock
owner who purchases the October 45 put would have amaximum risk of½ point, for
he could always exercise the put to sell stock at 45, giving him a 5-point gain on the
stock, but he paid 5½ points for the put, thereby giving him an overall maximum loss
of ½ point. He would have difficulty making any profit during the life of the put,
however. XYZ would have to rise by more than 5½ points (the cost of the put) for
him to make any total profit on the position by October expiration.
The deep in-the-money put purchase is overly conservative and is usually not agood strategy. On the other hand, it is not wise to purchase aput that is too deeply
out-of-the-money as protection. Generally, one should purchase aslightly out-ofthe
money put as protection. This helps to achieve abalance between the positive feature
of protection for the common stock and the negative feature of limiting profits.
The reader may find it interesting to know that he has actually gone through this
analysis, back in Chapter 3. Glance again at the profit graph for this strategy of using
the put purchase to protect acommon stock holding (Figure 17-1). It has exactly the
same shape as the profit graph of asimple call purchase. Therefore, the call purchase
and the long put/long stock strategies are equivalent. Again, by equivalent it is meant
that they have similar profit potentials. Obviously, the ownership of acall differs sub
stantially from the ownership of common stock and aput. The stock owner continues
to maintain his position for an indefinite period of time, while the call holder does not.
Also, the stockholder is forced to pay substantially more for his position than is the call
holder, and he also receives dividends whereas the call holder does not. Therefore,
"equivalent" does not mean exactly the same when comparing call-oriented and put
oriented strategies, but rather denotes that they have similar profit potentials.
In Chapter 3, it was determined that the slightly in-the-money call often offers
the best ratio between risk and reward. When the call is slightly in-the-money, the
stock is above the striking price. Similarly, the slightly out-of-the-money put often
offers the best ratio between risk and reward for the common stockholder who is buy
ing the put for protection. Again, the stock is slightly above the striking price. Actually,
since the two positions are equivalent, the same conclusions should be arrived at; that
is why it was stated that the reader has been through this analysis previously.

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G,pter 17: Put Buying in Conjunction with Common Stock Ownership
TAX CONSIDERATIONS
275
Although tax considerations are covered in detail in alater chapter, an important tax
law concerning the purchase of puts against acommon stock holding should be men
tioned at this time. If the stock owner is already along-term holder of the stock at the
time that he buys the put, the put purchase has no effect on his tax status. Similarly,
if the stock buyer buys the stock at the time that he buys the put and identifies the
position as ahedge, there is no effect on the tax status of his stock. However, if one
Is currently ashort-tenn holder of the common stock at the time that he buys aput,
he eliminates any accrued holding period on his common stock. Moreover, the hold
ing period for that stock does not begin again until the put is sold.
Example: Assume the long-term holding period is 6 months. That is, astock owner
must own the stock for 6 months before it can be considered along-term capital gain.
An investor who bought the stock and held it for 5 months and then purchased aput
would wipe out his entire holding period of 5 months. Suppose he then held the put
and the stock simultaneously for 6 months, liquidating the put at the end of 6 months.
His holding period would start all over again for that common stock. Even though he
has owned the stock for 11 months - 5 months prior to the put purchase and 6
months more while he simultaneously owned the put - his holding period for tax pur
poses is considered to be zero!
This law could have important tax ramifications, and one should consult atax advisor
if he is in doubt as to the effect that aput purchase might have on the taxability of
his common stock holdings.
PUT BUYING AS PROTECTION FOR THE COVERED CALL WRITER
Since put purchases afford protection to the owner of common stock, some investors
naturally feel that the same protective feature could be used to limit their downside
risk in the covered call writing strategy. Recall that the covered call writing strategy
involves the purchase of stock and the sale of acall option against that stock. The cov
ered write has limited upside profit potential and offers protection to the downside in
the amount of the call premium. The covered writer will make money if the stock falls
alittle, remains unchanged, or rises by expiration. The covered writer can actually lose
money only if the stock falls by more than the call premium received. He has poten
tially large downside losses. This strategy is known as aprotective collar or, more sim
ply, a "collar." (It is also called a "hedge wrapper," although that is an outdated term.)

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274 Part Ill: Put Option Strategies
At the opposite end of the spectrum, the stock owner might buy an in-the
money put as protection. This would quite severely limit his profit potential, since the
underlying stock would have to rise above the stiike and more for him to make aprofit. However, the in-the-money put provides vast quantities of downside protec
tion, limiting his loss to avery small amount.
Example: XYZ is again at 40 and there is an October 45 put selling for 5½. The stock
owner who purchases the October 45 put would have amaximum risk of½ point, for
he could always exercise the put to sell stock at 45, giving him a 5-point gain on the
stock, but he paid 5½ points for the put, thereby giving him an overall maximum loss
of ½ point. He would have difficulty making any profit during the life of the put,
however. XYZ would have to rise by more than 5½ points (the cost of the put) for
him to make any total profit on the position by October expiration.
The deep in-the-money put purchase is overly conservative and is usually not agood strategy. On the other hand, it is not wise to purchase aput that is too deeply
out-of-the-money as protection. Generally, one should purchase aslightly out-ofthe
nwney put as protection. This helps to achieve abalance between the positive feature
of protection for the common stock and the negative feature of limiting profits.
The reader may find it interesting to know that he has actually gone through this
analysis, back in Chapter 3. Glance again at the profit graph for this strategy of using
the put purchase to protect acommon stock holding (Figure 17-1). It has exactly the
same shape as the profit graph of asimple call purchase. Therefore, the call purchase
and the long put/long stock strategies are equivalent. Again, by equivalent it is meant
that they have similar profit potentials. Obviously, the ovvnership of acall differs sub
stantially from the ownership of common stock and aput. The stock owner continues
to maintain his position for an indefinite period of time, while the call holder does not.
Also, the stockholder is forced to pay substantially more for his position than is the call
holder, and he also receives dividends whereas the call holder does not. Therefore,
"equivalent" does not mean exactly the same when comparing call-oriented and put
oriented strategies, but rather denotes that they have similar profit potentials.
In Chapter 3, it was determined that the slightly in-the-money call often offers
the best ratio between 1isk and reward. When the call is slightly in-the-money, the
stock is above the striking price. Similarly, the slightly out-of-the-money put often
offers the best ratio between risk and reward for the common stockholder who is buy
ing the put for protection. Again, the stock is slightly above the striking price. Actually,
since the two positions are equivalent, the same conclusions should be arrived at; that
is why it was stated that the reader has been through this analysis previously.

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0.,,,,, I 7: Put Buying in Conjundion with Common Stock Ownership
JAX CONSIDERATIONS
275
Although tax considerations are covered in detail in alater chapter, an important tax
law concerning the purchase of puts against acommon stock holding should be men
tioned at this time. If the stock owner is already along-term holder of the stock at the
time that he buys the put, the put purchase has no effect on his tax status. Similarly,
if the stock buyer buys the stock at the time that he buys the put and identifies the
position as ahedge, there is no effect on the tax status of his stock. However, if one
is currently ashort-term holder of the comrrwn stock at the time that he buys aput,
he eliminates any accrued holding period on his comrrwn stock. Moreover, the hold
ing period for that stock does not begin again until the put is sold.
Example: Assume the long-term holding period is 6 months. That is, astock owner
must own the stock for 6 months before it can be considered along-term capital gain.
An investor who bought the stock and held it for 5 months and then purchased aput
would wipe out his entire holding period of 5 months. Suppose he then held the put
and the stock simultaneously for 6 months, liquidating the put at the end of 6 months.
His holding period would start all over again for that common stock. Even though he
has owned the stock for 11 months - 5 months prior to the put purchase and 6
months more while he simultaneously owned the put - his holding period for tax pur
poses is considered to be zero!
This law could have important tax ramifications, and one should consult atax advisor
if he is in doubt as to the effect that aput purchase might have on the taxability of
his common stock holdings.
PUT BUYING AS PROTECTION FOR THE COVERED CALL WRITER
Since put purchases afford protection to the owner of common stock, some investors
naturally feel that the same protective feature could be used to limit their downside
risk in the covered call writing strategy. Recall that the covered call writing strategy
involves the purchase of stock and the sale of acall option against that stock. The cov
ered write has limited upside profit potential and offers protection to the downside in
the amount of the call premium. The covered writer will make money if the stock falls
alittle, remains unchanged, or rises by expiration. The covered writer can actually lose
money only if the stock falls by more than the call premium received. He has poten
tially large downside losses. This strategy is known as aprotective collar or, more sim
ply, a "collar." (It is also called a "hedge wrapper," although that is an outdated term.)

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276 Part Ill: Put Option Strategies
The purchase of an out-of the-money put option can eliminate the risk of large
potential losses for the covered write, although the money spent for the put purchase
will reduce the overall return from the covered write. One must therefore include
the put cost in his initial calculations to determine if it is worthwhile to buy the put.
Example: X'YZ is at 39 and there is an XYZ October 40 call selling for 3 points and an
XYZ October 35 put selling for ½ point. Acovered write could be established by buy
ing the common at 39 and selling the October 40 call for 3. This covered write would
have amaximum profit potential of 4 points if XYZ were anywhere above 40 at expi
ration. The write would lose money if XYZ were anywhere below 36, the break-even
point, at October expiration. By also purchasing the October 35 put at the time the
covered write is initiated, the covered writer will limit his profit potential slightly, but
will also greatly reduce his risk potential. If the put purchase is added to the covered
write, the maximum profit potential is reduced to 3½ points at October expiration. The
break-even point moves up to 36½, and the writer will experience some loss if XYZ is
below 36½ at expiration. However, the most that the writer could lose would be 1 ¼
points if XYZ were below 35 at expiration. The purchase of the put option produces
this loss-limiting effect. Table 17-2 and Figure 17-2 depict the profitability of both the
regular covered write and the covered write that is protected by the put purchase.
Commissions should be carefully included in the covered writer'sreturn calcula
tions, as well as the cost of the put. It was demonstrated in Chapter 2 that the covered
writer must include all commissions and margin interest expenses as well as all divi
dends received in order to produce an accurate "total return" picture of the covered
write. Figure 17-2 shows that the break-even point is raised slightly and the overall prof
it potential is reduced by the purchase of the put. However, the maximum risk is quite
small and the writer need never be forced to roll down in adisadvantageous situation.
Recall that the covered writer who does not have the protective put in place is
forced to roll down in order to gain increased downside protection. Rolling down
merely means that he buys back the call that is currently written and writes another
call, with alower striking price, in its place. This rolling-down action can be helpful
if the stock stabilizes after falling; but if the stock reverses and climbs upward in price
again, the covered writer who rolled down would have limited his gains. In fact, he
may even have "locked in" aloss. The writer who has the protective put need not be
bothered with such things. He never has to roll down, for he has alimited maximum
loss. Therefore, he should never get into a "locked-in" loss situation. This can be agreat advantage, especially from an emotional viewpoint, because the writer is never
forced to make adecision as to the future price of the stock in the middle of the
stock'sdecline. With the put in place, he can feel free to take no action at all, since
his overall loss is limited. If the stock should rally upward later, he will still be in aposition to make his maximum profit.

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Chapter 17: Put Buying in Conjundion with Common Stock Ownership
TABLE 17·2.
Comparison of regular and protected covered writes.
XYZ Price at Stock October 40 October 35
Expiration Profit Call Profit Put Profit
25 -$1,400 +$300 +$950
30 900 + 300 + 450
35 400 + 300 - 50
36.50 250 + 300 - 50
38 100 + 300 - 50
40 + 100 + 300 - 50
45 + 600 - 200 - 50
50 + 1,100 - 700 - 50
FIGURE 17-2.
Covered call write protected by aput purchase.
C
0
e ·5.
X
LU
co $0 CJ)
CJ)
0 .J
0
~ -$150 a..
,,
},.,,'
;
,,
Regular
Covered ,,'
Write/
36 / , ,
;
,,'
+$400
,----------➔ ,,,' _____ ...,..
, +$350
,,,'
40
Stock Price at Expiration
277
Total
Profit
-$150
- 150
- 150
0
+ 150
+ 350
+ 350
+ 350
The longer-term effects of buying puts in combination with covered writes are
not easily definable, but it would appear that the writer reduces his overall rate of
return slightly by buying the puts. This is because he gives something away if the
stock falls slightly, remains unchanged, or rises in price. He only "gains" something if
the stock falls heavily. Since the odds of astock falling heavily are small in compari
son to the other events (falling slightly, remaining unchanged, or rising), the writer
will be gaining something in only asmall percentage of cases. However, the put buy
ing strategy may still prove useful in that it removes the emotional uncertainty of

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278 Part Ill: Put Option Strategies
large losses. The covered writer who buys puts may often find it easier to operate in
amore rational manner when he has the protective put in place.
This strategy is equivalent to one that has been described before, the bull
spread. Notice that the profit graph in Figure 17-2 has the same shape as the bull
spread profit graph (Figure 7-1). This means that the two strategies are equivalent.
In fact, in Chapter 7 it was pointed out that the bull spread could sometimes be con
sidered a "substitute" for covered writing. Actually, the bull spread is more akin to
this strategy - the covered write protected by aput purchase. There are, of course,
differences between the strategies. They are equivalent in profit and loss potential,
but the covered writer could never lose all his investment in ashort period of time,
although the spreader could. In order to actually use bull spreads as substitutes for
covered writes, one would invest only asmall portion of his available funds in the
spread and would place the remainder of his funds in fixed-income securities. That
strategy was discussed in more depth in Chapter 7.
NO-COST COLLARS
The "collar" strategy is often arrived at in another manner: astockholder begins
to worry about the downside potential of the stock market and decides to buy puts
on his stock as protection. However, he is dismayed by the cost of the puts and so he
also considers the sale of calls. If he buys an out-of-the-money put, it is quite possi
ble that he might be able to sell an out-of-the-money call whose proceeds complete
ly cover the cost of the put. Thus, he has established aprotective collar at no cost -
at least no debit. His "cost" is the fact that he has forsaken the upside profit poten
tial on his stock, above the striking price of the written call.
In fact, certain large institutional traders are able to transact collars through
large over-the-counter option brokers, such as Goldman Sachs or Morgan Stanley.
They might even give the broker instructions such as this: "Iown XYZ and Iwant to
buy aput 10 percent out of the money that expires in ayear. What would the strik
ing price of aone-year call have to be in order to create ano-cost collar?" The bro
ker might then tell him that such acall would have to be struck 30 percent out of the
money. The actual strike price of the call would depend on the volatility estimate for
the underlying stock, as well as interest rates and dividends. These types of transac
tions occur with afair amount of frequency.
Some very interesting situations can be created with long-term options. One of
the most interesting occurred in 1999, when acompany that owned 5 million shares
of Cisco ( CSCO) decided it would like to hedge them by creating ano-cost collar
over the next three years. At the time, CSCO was trading at about 130, and its volatil
ity was about 50%. It turns out that athree-year put struck at 130 sells for about the

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278 Part Ill: Put Option Strategies
large losses. The covered writer who buys puts may often find it easier to operate in
amore rational manner when he has the protective put in place.
This strategy is equivalent to one that has been described before, the bull
spread. Notice that the profit graph in Figure 17-2 has the same shape as the bull
spread profit graph (Figure 7-1). This means that the two strategies are equivalent.
In fact, in Chapter 7 it was pointed out that the bull spread could sometimes be con
sidered a "substitute" for covered writing. Actually, the bull spread is more akin to
this strategy- the covered write protected by aput purchase. There are, of course,
differences between the strategies. They are equivalent in profit and loss potential,
but the covered writer could never lose all his investment in ashort period of time,
although the spreader could. In order to actually use bull spreads as substitutes for
covered writes, one would invest only asmall portion of his available funds in the
spread and would place the remainder of his funds in fixed-income securities. That
strategy was discussed in more depth in Chapter 7.
NO-COST COLLARS
The "collar" strategy is often arrived at in another manner: astockholder begins
to worry about the downside potential of the stock market and decides to buy puts
on his stock as protection. However, he is dismayed by the cost of the puts and so he
also considers the sale of calls. If he buys an out-of-the-money put, it is quite possi
ble that he might be able to sell an out-of-the-money call whose proceeds complete
ly cover the cost of the put. Thus, he has established aprotective collar at no cost -
at least no debit. His "cost" is the fact that he has forsaken the upside profit poten
tial on his stock, above the striking price of the written call.
In fact, certain large institutional traders are able to transact collars through
large over-the-counter option brokers, such as Goldman Sachs or Morgan Stanley.
They might even give the broker instructions such as this: "Iown XYZ and Iwant to
buy aput 10 percent out of the money that e.:\.J)ires in ayear. What would the strik
ing price of aone-year call have to be in order to create ano-cost collar?" The bro
ker might then tell him that such acall would have to be struck 30 percent out of the
money. The actual strike price of the call would depend on the volatility estimate for
the underlying stock, as well as interest rates and dividends. These types of transac
tions occur with afair amount of frequency.
Some very interesting situations can be created with long-term options. One of
the most interesting occurred in 1999, when acompany that owned 5 million shares
of Cisco (CSCO) decided it would like to hedge them by creating ano-cost collar
over the next three years. At the time, CSCO was trading at about 130, and its volatil
ity was about 50%. It turns out that athree-year put struck at 130 sells for about the

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278 Part Ill: Put Option Strategies
large losses. The covered writer who buys puts may often find it easier to operate in
amore rational manner when he has the protective put in place.
This strategy is equivalent to one that has been described before, the bull
spread. Notice that the profit graph in Figure 17-2 has the same shape as the bull
spread profit graph (Figure 7-1). This means that the two strategies are equivalent.
In fact, in Chapter 7 it was pointed out that the bull spread could sometimes be con
sidered a "substitute" for covered writing. Actually, the bull spread is more akin to
this strategy - the covered write protected by aput purchase. There are, of course,
differences between the strategies. They are equivalent in profit and loss potential,
but the covered writer could never lose all his investment in ashort period of time,
although the spreader could. In order to actually use bull spreads as substitutes for
covered ,vrites, one would invest only asmall portion of his available funds in the
spread and would place the remainder of his funds in fixed-income securities. That
strategy was discussed in more depth in Chapter 7.
NO-COST COLLARS
The "collar" strategy is often arrived at in another manner: astockholder begins
to worry about the downside potential of the stock market and decides to buy puts
on his stock as protection. However, he is dismayed by the cost of the puts and so he
also considers the sale of calls. If he buys an out-of-the-money put, it is quite possi
ble that he might be able to sell an out-of-the-money call whose proceeds complete
ly cover the cost of the put. Thus, he has established aprotective collar at no cost -
at least no debit. His "cost" is the fact that he has forsaken the upside profit poten
tial on his stock, above the striking price of the written call.
In fact, certain large institutional traders are able to transact collars through
large over-the-counter option brokers, such as Goldman Sachs or Morgan Stanley.
They might even give the broker instructions such as this: "Iown XYZ and Iwant to
buy aput 10 percent out of the money that expires in ayear. What would the strik
ing p1ice of aone-year call have to be in order to create ano-cost collar?" The bro
ker might then tell him that such acall would have to be struck 30 percent out of the
money. The actual strike price of the call would depend on the volatility estimate for
the underlying stock, as well as interest rates and dividends. These types of transac
tions occur with afair amount of frequency.
Some very interesting situations can be created with long-term options. One of
the most interesting occurred in 1999, when acompany that owned 5 million shares
of Cisco ( CSCO) decided it would like to hedge them by creating ano-cost collar
over the next three years. At the time, CSCO was trading at about 130, and its volatil
ity was about 50%. It turns out that athree-year put struck at 130 sells for about the

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Cltapter 17: Put Buying in Conjunction with Common Stock Ownership
TABLE 17-3.
Highest Call Strike That Pays for an At-the-Money Put
(Assuming 2.5 years to expiration)
Volatility Coll Strike
30%
40%
50%
70%
100%
of Underlying
30% out of money
35% out of money
40% out of money
50% out of money
70% out of money
279
same price as athree-year call struck at 200! That may seem illogical, but the figures
can be checked out with the aid of an option-pricing model. Thus, this company was
able to hedge all of its CSCO stock, with no downside risk ( the striking price of the
puts was the same as the current stock price) and still had profit potential of over 50%
to the upside over the next three years.
Thus, one should consider using LEAPS options when he establishes acollar -
even ifhe is not an institutional trader - because the striking price of the calls can be
quite high in comparison to that of the put' sstrike or in comparison to the price of
the underlying stock. Table 17-3 shows how far out-of-the-money awritten call could
be that still covers the cost of buying an at-the-money put. The time to expiration in
this table is 2.5 years - the longest term listed option that currently exists as a LEAPS
option.
USING LOWER STRIKES AS A PARTIAL COVERED WRITE
It should also be pointed out that one does not necessarily have to forsake all of
the profit potential from his stock. He might buy the puts, as usual, and then sell calls
with asomewhat lower strike than needed for alow-cost collar, but the quantity of
calls sold would be less than that of stock owned. In that way, there would be unlim
ited profit potential on some of the shares of the underlying stock.
Example: Suppose that the following prices exist:
XYZ:61
Apr 55 put: 1
Apr 65 call: 2
Furthermore, suppose that one owns 1000 shares of XYZ. Thus, the purchase
of 10 Apr 55 puts at 1 point apiece would protect the downside. In order to cover the
cost of those puts ($1000), one need only sell five of the Apr 65 calls at 2 points

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280 Part Ill: Put Option Strategies
apiece. Thus, the protection would have cost nothing and there would still be unlim
ited profit potential on 500 of the shares of XYZ, since only five calls were sold against
the 1000 shares that are owned.
In this manner, one could get quite creative in constructing collars - deciding
what call strike to use in order to strike abalance between paying for the puts and
allowing upside profit potential. The lower the strike he uses for the written calls, the
fewer calls he will have to write; the higher the strike of the written calls, the more
calls will be necessary to cover the cost of the purchased puts. The tradeoff is that alower call strike allows for more eventual upside profit potential, but it limits what
has been written against to alower price.
Using the above example once again, these facts can be demonstrated:
Example (continued): As before, the same prices exist, but now one more call will
be brought into the picture:
XYZ: 61
Apr55 put: l
Apr 65 call: 2
Apr 70 call: l
As before one could sell five of the Apr 65 calls to cover the cost of ten puts, or
as an alternative he could sell ten of the Apr 70 calls. If he sells the five, he has unlim
ited profit potential on 500 shares, but the other 500 shares will be called away at 65.
In the alternative strategy, he has limited upside profit potential, but nothing will be
called away until the stock reaches 70. Which is "better?" It'snot easy to say. In the
former strategy, if the stock climbs all the way to 75, it results in the same profit as if
the stock is called away at 70 in the latter strategy. This is true because 500 shares
would be worth 75, but the other 500 would have been called away at 65 - making
for an average of 70. Hence, the former strategy only outperforms the latter if the
stock actually climbs above 75 - arather unlikely event, one would have to surmise.
Still, many investors prefer the former strategy because it gives them protection with
out asking them to surrender all of their upside profit potential.
In summary, one can often be quite creative with the "collar" strategy. One thing
to keep in mind: if one sells options against stock that he has no intention of selling, he
is actually writing naked calls in his ovm mind. That is, if one owns stock that "can't"
be sold - perhaps the capital gains would be devastating or the stock has been "in the
family" for along time - then he should not sell covered calls against it, because he will
be forced into treating the calls as naked (if he refuses to sell the stock). This can cause
quite abit of consternation if the underlying stock rises significantly in price, that could
have easily been avoided by not writing calls against the stock in the first place.

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CHAPCIJER 18
Buying Puts in Conjunction
with Call Purchases
There are several ways in which the purchases of both puts and calls can be used to
the speculator'sadvantage. One simple method is actually afollow-up strategy for the
call buyer. If the stock has advanced and the call buyer has aprofit, he might con
sider buying aput as ameans of locking in his call profits while still allowing for more
potential upside appreciation. In Chapter 3, four basic alternatives were listed for the
call buyer who had aprofit: He could liquidate the call and take his profit; he could
do nothing; he could "roll up" by selling the call for aprofit and using part of the pro
ceeds to purchase more out-of-the-money calls; or he could create abull spread by
selling the out-of-the-money call against the profitable call that he holds. If the
underlying stock has listed puts, he has another alternative: He could buy aput. This
put purchase would serve to lock in some of the profits on the call and would still
allow room for further appreciation if the stock should continue to rise in price.
Example: An investor initially purchased an XYZ October 50 call for 3 points when
the stock was at 48. Sometime later, after the stock had risen to 58, the call would be
worth about 9 points. If there was an October 60 put, it might be selling for 4 points,
and the call holder could buy this put to lock in some of his profits. His position, after
purchasing the put, would be:
Long l October 50 call at 3 points Ntt 7 • t - ecos: pom s Long l October 60 put at 4 points
He would own a "strangle" - any position consisting of both aput and acall with dif
fering terms - that is always worth at least 10 points. The combination will be worth
exactly 10 points at expiration if XYZ is anywhere between 50 and 60. For example,
281

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282 Part Ill: Put Option Strategies
if xyz is at 52 at expiration, the call will be worth 2 points and the put will be wort Ii
8 points. Alternatively, if the stock is at 58 at expiration, the put will be worth 2 points
and the call worth 8 points. Should xyz be above 60 at expiration, the combination'svalue will be equal to the call'svalue, since the put will expire worthless with XYZ
above 60. The call would have to be worth more than 10 points in that case, since it
has astriking price of 50. Similarly, if xyz were below 50 at expiration, the combi
nation would be worth more than 10 points, since the put would be more than 10
points in-the-money and the call would be worthless.
The speculator has thus created aposition in which he cannot lose money,
because he paid only 7 points for the combination (3 points for the call and 4 points
for the put). No matter what happens, the combination will be worth at least 10
points at e:x-piration, and a 3-point profit is thus locked in. If xyz should continue to
climb in price, the speculator could make more than 3 points of profit whenever xyz
is above 60 at expiration. Moreover, if xyz should suddenly collapse in price, the
speculator could make more than 3 points of profit if the stock was below 50 by expi
ration. The reader must realize that such aposition can never be created as an initial
position. This desirable situation arose only because the call had built up asubstan
tial profit before the put was purchased. The similar strategy for the put buyer who
might buy acall to protect his unrealized put profits was described in Chapter 16.
STRADDLE BUYING
Astraddle purchase consists of buying both aput and acall with the same terms -
sarne underlying stock, striking price, and expiration date. The straddle purchase
allows the buyer to make large potential profits if the stock moves far enough in
either direction. The buyer has apredetermined maximum loss, equal to the amount
of his initial investment.
Example: The following prices exist:
xyz common, 50;
XYZ July 50 call, 3; and
XYZ July 50 put, 2.
If one purchased both the July 50 call and the July 50 put, he would be buying astraddle. This would cost 5 points plus commissions. The investment required to
purchase astraddle is the net debit. If the underlying stock is exactly at 50 at expi
ration, the buyer would lose all his investment, since both the put and the call would
expire worthless. If the stock were above .55 at expiration, the call portion of the

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18: Buying Puts in Conjundion with Call Purchases 283
dle would be worth more than 5 points and the straddle buyer would make
y, even though his put expired worthless. To the downside, asimilar situation
Mists. If XYZ were below 45 at expiration, the put would be worth more than 5
points and he would have aprofit despite the fact that the call expired worthless.
Table 18-1 and Figure 18-1 depict the results of this example straddle purchase at
expiration. The straddle buyer can immediately determine his break-even points at
expiration - 45 and 55 in this example. He will lose money if the underlying stock is
between those break-even points at expiration. He has potentially large profits if
XYZ should move agreat distance away from 50 by expiration.
One would normally purchase astraddle on arelatively volatile stock that has
the potential to move far enough to make the straddle profitable in the allotted time.
This strategy is particularly attractive when option premiums are low, since low pre
miums will mean acheaper straddle cost. Although losses may occur in arelatively
large percentage of cases that are held all the way until their expiration date, there is
actually only aminute probability of losing one'sentire investment. Even if XYZ
should be at 50 at expiration, there would still be the opportunity to sell the straddle
for asmall amount on the final day of trading.
TABLE 18-1.
Results of straddle purchase at expiration.
XYZ Price at Total Straddle
Expiration Coll Profit Put Profit Profit
30 -$ 300 +$1,800 + $1,500
40 300 + 800 + 500
45 300 + 300 0
50 300 200 500
55 + 200 200 0
60 + 700 200 + 500
70 + 1,700 200 + 1,500
EQUIVALENCES
Straddle buying is equivalent to the reverse hedge, astrategy described in Chapter 4
in which one sells the underlying stock short and purchases two calls on the under
lying stock. Both strategies have similar profit characteristics: alimited loss that
would occur at the striking price of the options involved, and potentially large prof
its if the underlying stock should rise or fall far enough in price. The straddle pur-

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284
FIGURE 18-1.
Straddle purchase.
C:
.Q
I!! ·a.
Xwro $0 en en 0
..J
0
-ea..
-$500
Part Ill: Put Option Strategies
Stock Price at Expiration
chase is superior to the reverse hedge, however, and where listed puts exist on astock,
the reverse hedge strategy becomes obsolete. The reasons that the straddle purchase
is superior are that dividends are not paid by the holder and that commission costs
are much smaller in the straddle situation.
REVERSE HEDGE WITH PUTS
Athird strategy is equivalent to both the straddle purchase and the reverse hedge.
It consists of buying the underlying stock and buying two put options. If the stock
rises substantially in price, large profits will accrue, for the stock profit will more
than offset the fixed loss on the purchase of two put options. If the stock declines in
price by alarge amount, profits will also be generated. In adecline, the profits gen
erated by 2 long puts will more than offset the loss on 100 shares of long stock. This
form of the straddle purchase has limited risk as well. The worst case would occur
if the stock were exactly at the striking price of the puts at their expiration date - the
puts would both expire worthless. The risk is limited, percentagevvise and dollar
wise, since the cost of two put options would normally be arelatively small per
centage of the total cost of buying the stock. Furthermore, the investor may receive
some dividends if the underlying stock is adividend-paying stock. Buying stock and
buying two puts is superior to the reverse hedge strategy, but is still inferior to the
straddle purchase.

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ter 18: Buying Puts in Conjunction with Call Purchases
IILECTING A STRADDLE BUY
285
In theory, one could find the best straddle purchases by applying the analyses for best
call purchases and best put purchases simultaneously. Then, if both the puts and calls
on aparticular stock showed attractive opportunity, the straddle could be bought.
The straddle should be viewed as an entire position. Asimilar sort of analysis to that
proposed for either put or call purchases could be used for straddles as well. First,
one would assume the stock would move up or down in accordance with its volatili
ty within afixed time period, such as 60 or 90 days. Then, the prices of both the put
and the call could be predicted for this stock movement. The straddles that off er the
best reward opportunity under this analysis would be the most attractive ones to buy.
To demonstrate this sort of analysis, the previous example can be utilized again.
Example: XYZ is at 50 and the July 50 call is selling for 3 while the July 50 put is sell
ing for 2 points. If the strategist is able to determine that XYZ has a 25% chance of
being above 54 in 90 days and also has a 25% chance of being below 46 in 90 days,
he can then predict the option prices. Arigorous method for determining what per
centage chance astock has of making apredetermined price movement is presented
in Chapter 28 on mathematical applications. For now, ageneral procedure of analy
sis is more important than its actual implementation. If XYZ were at 54 in 90 days, it
might be reasonable to assume that the call would be worth 5½ and the put would
be worth 1 point. The straddle would therefore be worth 6½ points. Similarly, if the
stock were at 46 in 90 days, the put might be worth 4½ points, and the call worth 1
point, making the entire straddle worth 5½ points. It is fairly common for the strad
dle to be higher-priced when it is afixed distance in-the-money on the call side (such
as 4 points) than when it is in-the-money on the put side by that same distance. In
this example, the strategist has now determined that there is a 25% chance that the
straddle will be worth 6½ points in 90 days on an upside movement, and there is a
25% chance that the straddle will be worth 5½ points on adownside movement. The
average price of these two expectations is 6 points. Since the straddle is currently sell
ing for 5 points, this would represent a 20% profit. If all potential straddles are
ranked in the same manner - allowing for a 25% chance of upside and downside
movement by each underlying stock - the straddle buyer will have acommon basis
for comparing various straddle opportunities.
FOLLOW-UP ACTION
It has been mentioned frequently that there is agood chance that astock will remain
relatively unchanged over ashort time period. This does not mean that the stock will

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286 Part Ill: Put Option Strategies
never move much one way or the other, but that its net movement over the time peri
od will generally be small.
Example: If XYZ is currently at 50, one might say that its chances of being over .5.5
at the end of 90 days are fairly small, perhaps 30%. This may even be supported by
mathematical analysis based on the volatility of the underlying stock. This does not
imply, however, that the stock has only a 30% chance of ever reaching 55 during the
90-day period. Rather, it implies that it has only a 30% chance of being over 55 at the
end of the 90-day period. These are two distinctly different events, with different
probabilities of occurrence. Even though the probability of being over 55 at the end
of 90 days might be only 30%, the probability of ever being over 55 during the 90-
day period could be amazingly high, perhaps as high as 80%. It is important for the
straddle buyer to understand the differences between these events occurring, for he
might often be able to take follow-up action to improve his position.
Many times, after astraddle is bought, the underlying stock will begin to move
strongly, making it appear that the straddle is immediately going to become prof
itable. However, just as things are going well, the stock reverses and begins to change
direction, perhaps so quickly that it would now appear that the straddle will become
profitable on the other side. These volatile stock movements often result in little net
change, however, and at expiration the straddle buyer may have aloss. One might
think that he would take profits on the call side when they became available in aquick upward movement, and then hope for adownward reversal so that he could
take profits on the put side as well. Taking small profits, however, is apoor strategy.
Straddle buying has limited losses and potentially unlimited profits. One might have
to suffer through asubstantial number of small losses before hitting abig winner, but
the magnitude of the gain on that one large stock movement can offset many small
losses. By taking small profits, the straddle buyer is immediately cutting off his
chances for asubstantial gain; that is why it is apoor strategy to limit the profits.
This is one of those statements that sounds easier in theory than it is in practice.
It is emotionally distressing to watch the straddle gain 2 or 3 points in ashort time
period, only to lose that and more when the stock fails to follow through. By using adifferent example, it is possible to demonstrate the types of follow-up action that the
straddle buyer might take.
Example: One had initially bought an XYZ January 40 straddle for 6 points when the
stock was 40. After afairly short time, the stock jumps up to 45 and the following
prices exist:

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Cl,apter 18: Buying Puts in Conjunction with Call Purchases
XYZ common, 45:
XYZ January 40 call, 7;
XYZ January 40 put, l; and
XYZ January 45 put, 3.
287
The straddle itself is now worth 8 points. The January 45 put price is included
because it will be part of one of the follow-up strategies. What could the straddle
buyer do at this time? First, he might do nothing, preferring to let the straddle run
its course, at least for three months or so. Assuming that he is not content to sit tight,
however, he might sell the call, taking his profit, and hope for the stock to then drop
in price. This is an inferior course of action, since he would be cutting off potential
large profits to the upside.
In the older, over-the-counter option market, one might have tried atechnique
known as trading against the straddle. Since there was no secondary market for
over-the-counter options, straddle buyers often traded the stock itself against the
straddle that they owned. This type of follow-up action dictated that, if the stock
rose enough to make the straddle profitable to the upside, one would sell short the
underlying stock. This involved no extra risk, since if the stock continued up, the
straddle holder could always exercise his call to cover the short sale for aprofit.
Conversely, if the underlying stock fell at the outset, making the straddle profitable
to the downside, one would buy the underlying stock. Again, this involved no extra
risk if the stock continued down, since the put could always be exercised to sell the
stock at aprofit. The idea was to be able to capitalize on large stock price reversals
with the addition of the stock position to the straddle. This strategy worked best for
the brokers, who made numerous commissions as the trader tried to gauge the
whipsaws in the market. In the listed options market, the same strategic effect can
be realized ( without as large acommission expense) by merely selling out the long
call on an upward move, and using part of the proceeds to buy asecond put similar
to the one already held. On adownside move, one could sell out the long put for aprofit and buy asecond call similar to the one he already owns. In the example
above, the call would be sold for 7 points and asecond January 40 put purchased for
1 point. This would allow the straddle buyer to recover his initial 6-point cost and
would allow for large downside profit potential. This strategy is not recommended,
however, since the straddle buyer is limiting his profit in the direction that the stock
is moving. Once the stock has moved from 40 to 45, as in this example, it would be
more reasonable to expect that it could continue up rather than experience adrop
of more than 5 points.

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288 Part Ill: Put Option Strategies
Arrwre desirable sort off allow-up action would be one whereby the straddle
buyer could retain much of the profit already built up without limiting further poten
tial profits if the stock continues to run. In the example above, the straddle buyer
could use the January 45 put - the one at the higher price - for this purpose.
Example: Suppose that when the stock got to 45, he sold the put that he owned, the
January 40, for 1 point, and simultaneously bought the January 45 put for 3 points.
This transaction would cost 2 points, and would leave him in the following position:
Long 1 January 40 call Cb· dt 8 . t - om me cos : porn s Long 1 January 45 put
He now owns acombination at acost of 8 points. However, no matter where the
underlying stock is at expiration, this combination will be worth at least 5 points,
since the put has astriking price 5 points higher than the call'sstriking price. In fact,
if the stock is above 45 at expiration or is below 40 at expiration, the straddle will be
worth more than 5 points. This follow-up action has not limited the potential profits.
If the stock continues to rise in price, the call will become more and more valuable.
On the other hand, if the stock reverses and falls dramatically, the put will become
quite valuable. In either case, the opportunity for large potential profits remains.
Moreover, the investor has improved his risk exposure. The most that the new posi
tion can lose at expiration is 3 points, since the combination cost 8 points originally,
and can be sold for 5 points at worst.
To summarize, if the underlying stock moves up to the ne:t"tstrike, the straddle
buyer should consider rolling his put up, selling the one that he is long and buying
the one at the next higher striking price. Conversely, if the stock starts out with adownward move, he should consider rolling the call down, selling the one that he is
long and buying the one at the next lower strike. In either case, he reduces his risk
exposure without limiting his profit potential - exactly the type of follow-up result
that the straddle buyer should be aiming for.
BUYING A STRANGLE
Astrangle is aposition that consists of both aput and acall, which generally have the
same expiration date, but different striking prices. The fallowing example depicts astrangle.
Example: One might buy astrangle consisting of an XYZ January 45 put and an XYZ
January 50 call. Buying such astrangle is quite similar to buying astraddle, although

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