on for the diagonal spread is to have the stock near the striking price
of the written call. The figures demonstrate that the diagonal spread gives up a small
portion of potential upside profits to provide a hedge to the downside.
Once the April 35 call expires, the diagonal spread can be closed. However, if
the stock is below 35 at that time, it may be more prudent to then sell the July 35 call
against the July 30 call that is held long. This would establish a normal bull spread for
the 3 months remaining until July expiration. Note that ifXYZ were still at 32 at April
expiration, the July 35 call might be sold for 1 point if the stock's volatility was about
the same. This should be true, since the April 35 call was worth 1 point with the stock
at 32 three months before expiration. Consequently, the strategist who had pursued
this course of action would end up with a normal July bull spread for a net debit of 2
points: He originally paid 4 for the July 30 call, but then sold the April 35 for 1 point
and subsequently sold the July 35 for 1 point. By looking at the table of prices for the
first example in this chapter, the reader can see that it would have cost 2½ points to
set up the normal July bull spread originally. Thus, by diagonalizing and having the
near-term call expire worthless, the strategist is able to acquire the normal July bull
spread at a cheaper cost than he could have originally. This is a specific example of
how the diagonalizing effect can prove beneficial if the writer is able to write against
the same long call two times, or three times if he originally purchased the longest
term call. In this example, if XYZ were anywhere between 30 and 35 at April expira
tion, the spread would be converted to a normal July bull spread. If the stock were
above 35, the spread should be closed to take the profit. Below 30, the July 30 call
would probably be closed or left outright long.
Chapter 14: Diagonalizing a Spread 239
In summary, the diagonal bull spread may often be an improvement over the
normal bull spread. The diagonal spread is an improvement when the stock remains
relatively unchanged or falls, up until the near-term written call expires. At that time,
the spread can be converted to a normal bull spread if the stock is at a favorable price.
Of course, if at any time the underlying stock rises above the higher striking price at
an expiration date, the diagonal spread will be profitable.
OWNING A CALL FOR "FREE"
Diagonalization can be used in other spread strategies to accomplish much the same
purposes already described; but in addition, it may also be possible for the spreader
to wind up owning a long call at a substantially reduced cost, possibly even for free.
The easiest w~y to see this would be to consider a diagonal bear spread.
Example: XYZ is at 32 and the near-term April 30 call is selling for 3 points while the
longer-term July 35 call is selling for 1 ½ points. A diagonal bear spread could be
established by selling the April 30 and buying the July 35. This is still a bear spread,
because a call with a lower striking price is being sold while a call at a higher strike
is being purchased. However, since the purchased call has a longer maturity date
than the written call, the spread is diagonalized.
This diagonal bear spread will make money ifXYZ falls in price before the near
term April call expires. For example, ifXYZ is at 29 at expiration, the written call will
expire worthless and the July 35 will still have some value, perhaps ½. Thus, the prof
it would be 3 points on the April 30, less a 1-point loss on the July 35, for an overall
profit of 2 points. The risk in the position lies to the upside, just as in a regular bear
spread. If XYZ should advance by a great deal, both options would be at parity and
the spread would have widened to 5 points. Since the initial credit was 1 ½ points, the
loss would be 5 minus 1 ½, or 3½ points in that case. As in all diagonal spreads, the
spread will do slightly better to the downside because the long call will hold some
value, but it will do slightly worse to the upside if the underlying stock advances sub
stantially.
The reason that a strategist might attempt a diagonal bear spread would not be
for the slight downside advantage that the diagonalizing effect produces. Rather it
would be because he has a chance of owning the July 35 call - the longer-term call -
for a substantially reduced cost. In the example, the cost of the July 35 call was 1 ½
points and the premium received from the sale of the April 30 call was 3 points. If
the spreader can make 1 ½ points from the sale of the April 30 call, he will have com
pletely covered the cost of his July option. He can then sit back and hope for a rally
240 Part II: Call Option Strategies
by the underlying stock. If such a rally occurred, he could make unlimited profits on
the long side. If it did not, he loses nothing.
Example: Assume that the same spread was established as in the last example. Then,
if XYZ is at or below 31 ½ at April expiration, the April 30 call can be purchased for
1 ½ points or less. Since the call was originally sold for 3, this would represent a prof
it of at least 1 ½ points on the April 30 call. This profit on the near-term option cov
ers the entire cost of the July 35. Consequently, the strategist owns the July 35 for
free. If XYZ never rallies above 35, he would make nothing from the overall trade.
However, if XYZ were to rally above 35 after April expiration (but before July expi
ration, of course), he could make potentially large profits. Thus, when one establish
es a diagonal spread for a credit, there is always the potential that he could own a call
for free. That is, the profits from the sale of the near-term call could equal or exceed
the original cost of the long call. This is, of course, a desirable position to be in, for if
the underlying stock should rally substantially after pro


he could make potentially large profits. Thus, when one establish
es a diagonal spread for a credit, there is always the potential that he could own a call
for free. That is, the profits from the sale of the near-term call could equal or exceed
the original cost of the long call. This is, of course, a desirable position to be in, for if
the underlying stock should rally substantially after profits are realized on the short
side, large profits could accrue.
DIAGONAL BACKSPREADS
In an analogous strategy, one might buy more than one longer-term call against the
short-term call that is sold. Using the foregoing prices, one might sell the April 30 for
3 points and buy 2 July 35's at 1 ½ points each. This would be an even money spread.
. The credits equal the debits when the position is established. If the April 30 call
expires worthless, which would happen if the stock was below 30 in April, the spread
er would own 2 July 35 calls for free. Even if the April 30 does not expire totally
worthless, but if some profit can be made on the sale of it, the July 35's will be owned
at a reduced cost. In Chapter 13, when reverse spreads were discussed, the strategy
in which one sells a call with a lower strike and then buys more calls at a higher strike
was termed a reverse ratio spread, or backspread. The strategy just described is
merely the diagonalizing of a backspread. This is a strategy that is favored by some
professionals, because the short call reduces the risk of owning the longer-term calls
if the underlying stock declines. Moreover, if the underlying stock advances, the pre
ponderance of long calls with a longer maturity will certainly outdistance the losses
on the written call. The worst situation that could result would be for the underlying
stock to rise very slightly by near-term expiration. If this happened, it might be pos
sible to lose money on both sides of the spread. This would have to be considered a
rather low-probability event, though, and would still represent a limited loss, so it
does not substantially offset the positive aspects of the strategy.
0.,ter 14: Diagonalizing a Spread 241
Any type of spread may be diagonalized. There are some who prefer to diago
nalize even butterfly spreads, figuring that the extra time to maturity in the purchased
calls will be of benefit. Overall, the benefits of diagonalizing can be generalized by
recalling the way in which the decay of the time value premium of a call takes place.
Recall that it was determined that a call loses most of its time value premium in the
last stages of its life. When it is a very long-term option, the rate of decay is small.
Knowing this fact, it makes sense that one would want to sell options with a short life
remaining, so that the maximum benefit of the decay could be obtained.
Correspondingly, the purchase of a longer-term call would mean that the buyer is not
subjecting himself to a substantial loss in time value premium, at least over the first
three months of ownership. A diagonal spread encompasses both of these features -
selling a short-term call to try to obtain the maximum rate of time decay, while buy
ing a longer-term call to try to lessen the effect of time decay on the long side.
CALL OPTION SUMMARY
This concludes the description of strategies that utilize only call options. The call
option has been seen to be a vehicle that the astute strategist can use to set up a wide
variety of positions. He can be bullish or bearish, aggressive or conservative. In addi
tion, he can attempt to be neutral, trying to capitalize on the probability that a stock
will not move very far in a short time period.
The investor who is not familiar with options should generally begin with a sim
ple strategy, such as covered call writing or outright call purchases. The simplest
types of spreads are the bull spread, the bear spread, and the calendar spread. The
more sophisticated investor might consider using ratios in his call strategies - ratio
writing against stock or ratio spreading using only calls.
Once the strategist feels that he understands the risk and reward relationships
between longer-term and short-term calls, between in-the-money and out-of-the
money calls, and between long calls and short calls, he could then consider utilizing
the most advanced types of strategies. This might include reverse ratio spreads, diag
onal spreads, and more advanced types of ratios, such as the ratio calendar spread.
A great deal of information, some of it rather technical in detail, has been pre
sented in preceding chapters. The best pattern for an investor to follow would be to
attempt only strategies that he fully comprehends. This does not mean that he mere
ly understands the profitability aspects (especially the risk) of the strategy. One must
also be able to readily understand the potential effects of early assignments, large div
idend payments, striking price adjustments, and the like, if he is going to operate
advanced strategies. Without a full understanding of how these things might affect
one's position, one cannot operate an advanced strategy correctly.

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INTRODUCTION
A put option gives the holder the right to sell the underlying security at the striking
price at any time until the expiration date of the option. Listed put options are
slightly newer than listed call options, having been introduced on June 3, 1977. The
introduction of listed puts has provided a much wider range of strategies for both
conservative and aggressive investors. The call option is least effective in strategies
in which downward price movement by the underlying stock is concerne

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ny time until the expiration date of the option. Listed put options are
slightly newer than listed call options, having been introduced on June 3, 1977. The
introduction of listed puts has provided a much wider range of strategies for both
conservative and aggressive investors. The call option is least effective in strategies
in which downward price movement by the underlying stock is concerned. The put
option is a useful tool in that case.
All stocks with listed call options have listed put options as well. The use of puts
or the combination of puts and calls can provide more versatility to the strategist.
When listed put options exist, it is no longer necessary to implement strategies
involving long calls and short stock. Listed put options can be used more efficiently
in such situations. There are many similarities between call strategies and put
strategies. For example, put spread strategies and call spread strategies employ sim
ilar tactics, although there are technical differences, of course. In certain strategies,
the tactics for puts may appear largely to be a repetition of those used for calls, but
they are nevertheless spelled out in detail here. The strategies that involve the use
of both puts and calls together - straddles and combinations - have techniques of
their own, but even in these cases the reader will recognize certain similarities to
strategies previously discussed. Thus, the introduction of put options not only
widens the realm of potential strategies, but also makes more efficient some of the
strategies previously described.
244
CH.APTER 15
Put Option Basics
Much of the same terminology that is applied to call options also pertains to put
options. Underlying security, striking price, and expiration date are all terms that
have the same meaning for puts as they do for calls. The expiration dates of listed put
options agree with the expiration dates of the calls on the same underlying stock. In
addition, puts and calls have the same striking prices. This means that if there are
options at a certain strike, say on a particular underlying stock that has both listed
puts and calls, both calls at 50 and puts at 50 will be trading, regardless of the price
of the underlying stock. Note that it is no longer sufficient to describe an option as
an "XYZ July 50." It must also be stated whether the option is a put or a call, for an
XYZ July 50 call and an XYZ July 50 put are two different securities.
In many respects, the put option and its associated strategies will be very near
ly the opposite of corresponding call-oriented strategies. However, it is not correct to
say that the put is exactly the opposite of a call. In this introductory section on puts,
the characteristics of puts are described in an attempt to show how they are similar
to calls and how they are not.
PUT STRATEGIES
In the simplest terms, the outright buyer of a put is hoping for a stock price decline
in order for his put to become more valuable. If the stock were to decline well below
the striking price of the put option, the put holder could make a profit. The holder
of the put could buy stock in the open market and then exercise his put to sell that
stock for a profit at the striking price, which is higher.
Example: If XYZ stock is at 40, an XYZ July 50 put would be worth at least 10 points,
for the put grants the holder the right to sell XYZ at 50 - 10 points above its current
245
INTRODUCTION
A put option gives the holder the right to sell the underlying security at the striking
price at any time until the expiration date of the option. Listed put options are
slightly newer than listed call options, having been introduced on June 3, 1977. The
introduction of listed puts has provided a much wider range of strategies for both
conservative and aggressive investors. The call option is least effective in strategies
in which downward price movement by the underlying stock is concerned. The put
option is a useful tool in that case.
All stocks with listed call options have listed put options as well. The use of puts
or the combination of puts and calls can provide more versatility to the strategist.
When listed put options exist, it is no longer necessary to implement strategies
involving long calls and short stock. Listed put options can be used more efficiently
in such situations. There are many similarities between call strategies and put
strategies. For example, put spread strategies and call spread strategies employ sim
ilar tactics, although there are technical differences, of course. In certain strategies,
the tactics for puts may appear largely to be a repetition of those used for calls, but
they are nevertheless spelled out in detail here. The strategies that involve the use
of both puts and calls together - straddles and combinations - have techniques of
their own, but even in these cases the reader will recognize certain similarities to
strategies previously discussed. Thus, the introduction of put options not only
widens the realm of potential strategies, but also makes more efficient some of the
strategies previously described.
244
CHAPTER 15
Put Option Basics
Much of the same terminology that is applied to call options also pertains to put
options. Underlying security, striking price, and expiration date are all terms that
have the same meaning for puts as they do for calls. The expiration dates of listed put
options agree with the expiration dates of the calls on the same underlying stock. In
addition, puts and calls have the same striking prices. This means that if there are
options at a certain strike, say on a particular underlying stock that has both listed
puts and calls, both calls at 50 and puts at 50 will be trading, regardless of the price
of the underlying stock. Note that it is no longer sufficient to describe an option as
an "XYZ July 50." It must also be stated whether the option is a put or a call, for an
X


riking prices. This means that if there are
options at a certain strike, say on a particular underlying stock that has both listed
puts and calls, both calls at 50 and puts at 50 will be trading, regardless of the price
of the underlying stock. Note that it is no longer sufficient to describe an option as
an "XYZ July 50." It must also be stated whether the option is a put or a call, for an
XYZ July 50 call and an XYZ July 50 put are two different securities.
In many respects, the put option and its associated strategies will be very near
ly the opposite of corresponding call-oriented strategies. However, it is not correct to
say that the put is exactly the opposite of a call. In this introductory section on puts,
the characteristics of puts are described in an attempt to show how they are similar
to calls and how they are not.
PUT STRATEGIES
In the simplest terms, the outright buyer of a put is hopingfor a stock price decline
in order for his put to become more valuable. If the stock were to decline well below
the striking price of the put option, the put holder could make a profit. The holder
of the put could buy stock in the open market and then exercise his put to sell that
stock for a profit at the striking price, which is higher.
Example: If XYZ stock is at 40, an XYZ July 50 put would be worth at least 10 points,
for the put grants the holder the right to sell XYZ at 50 10 points above its current
245
246 Part Ill: Put Option Strategies
price. On the other hand, if the stock price were above the striking price of the put
option at expiration, the put would be worthless. No one would logically want to exer
cise a put option to sell stock at the striking price when he could merely go to the
open market and sell the stock for a higher price. Thus, as the price of the underly
ing stock declines, the put becomes more valuable. This is, of course, the opposite of
a call option's price action.
The meaning of in-the-money and out-of-the-money are altered when one is
speaking of put options. A put is considered to be in-the-money when the underlying
stock is below the striking price of the put option; it is out-of the-money when the
stock is above the striking price. This, again, is the opposite of the call option. IfXYZ
is at 45, the XYZ July 50 put is in-the-money and the XYZ July 50 call is out-of-the
money. However, ifXYZ were at 55, the July 50 put would be out-of-the-money while
the July 50 call would be in-the-money. The broad definition of an in-the-money
option as "an option that has intrinsic value" would cover the situation for both puts
and calls. Note that a put option has intrinsic value when the underlying stock is
below the striking price of the put. That is, the put has some "real" value when the
stock is below the striking price.
The intrinsic value of an in-the-money put is merely the difference between
the striking price and the stock price. Since the put is an option (to sell), it will gen
erally sell for more than its intrinsic value when there is time remaining until the
expiration date. This excess value over its intrinsic value is referred to as the time
value premium, just as is the case with calls.
Example: XYZ is at 47 and the XYZ July 50 put is selling for 5, the intrinsic value is
3 points (50- 47), so the time value premium must be 2 points. The time value pre
mium of an in-the-money put option can always be quickly computed by the follow
ing formula:
Time value premium p . S k · St "ki · • ) == ut option + toe pnce - n ng pnce (m-the-money put
This is not the same formula that was applied to in-the-money call options, although
it is always true that the time value premium of an option is the excess value over
intrinsic value.
Time value premium Call ti S ·ki · St k · . all == op on + tn ng pnce - oc pnce (m-the-money c )
If the put is out-of-the-money, the entire premium of the put is composed of time
value premium, for the intrinsic value of an out-of-the-money option is always zero.
O.,,ter 15: Put Option Basks 247
The time value premium of a put is largest when the stock is at the striking price of
the put. As the option becomes deeply in-the-money or deeply out-of-the-money, the
time value premium will shrink substantially. These statements on the magnitude of
the time value premium are true for both puts and calls. Table 15-1 will help to illus
trate the relationship of stock price and option price for both puts and calls. The
reader may want to refer to Table 1-1, which described the time value premium rela
tionship for calls. Table 15-1 describes the prices of an XYZ July 50 call option and
an XYZ July 50 put option.
Table 15-1 demonstrates several basic facts. As the stock drops, the actual price
of a call option decreases while the value of the put option increases. Conversely, as
the stock rises, the call option increases in value and the put option decreases in
value. Both the put and the call have their maximum time value premium when the
stock is exactly at the striking price. However, the call will generally sell for rrwre than
the put when the stock is at the strike. Notice in Table 15-1 that, with XYZ at 50, the
call is worth 5 points while the put is worth only 4 points. This is true in general,
except in the case of a stock that pays a large dividend. This phenomenon has to do
with the cost of carrying stock. More will be said about this effect later. Table 15-1
also describes an effect of put options that normally holds true: An in-the-rrwney put
( stock is below strike) loses time value premium rrwre quickly than an in-the-rrwney
call does. Notice that with XYZ at 43 in Table 15-1, the put is 7 points in-the-money
and has lost all its time value premium. But when the call is 7 points in-the-money,
XYZ at 57, the call still has 2 points of time value premium. Again, this is a phenom
enon that could be affected by the dividend payout of the underlying stock, but is
true in


lue premium rrwre quickly than an in-the-rrwney
call does. Notice that with XYZ at 43 in Table 15-1, the put is 7 points in-the-money
and has lost all its time value premium. But when the call is 7 points in-the-money,
XYZ at 57, the call still has 2 points of time value premium. Again, this is a phenom
enon that could be affected by the dividend payout of the underlying stock, but is
true in general.
PRICING PUT OPTIONS
The same factors that determine the price of the call option also determine the price
of the put option: price of the underlying stock, striking price of the option, time
remaining until expiration, volatility of the underlying stock, dividend rate of the
underlying stock, and the current risk-free interest rate (Treasury bill rate, for exam
ple). Market dynamics - supply, demand, and investor psychology - play a part as
well.
Without going into as much detail as was shown in Chapter 1, the pricing curve
of the put option can be developed. Certain facts remain true for the put option as
they did for the call option. The rate of decay of the put option is not linear; that is,
the time value premium will decay more rapidly in the weeks immediately preced
ing expiration. The more volatile the underlying stock, the higher will be the price
248 Part Ill: Put Option Strategies
TABLE 15-1.
Call and put options compared.
XYZ XYZ Coll Coll XYZ Put Put
Stock July 50 Intrinsic Time Value July 50 Intrinsic Time Value
Price Coll Price Value Premium Put Price Value Premium
40 1/2 0 1/2 93/4 10 -1/4*
43 1 0 1 7 7 0
45 2 0 2 6 5
47 3 0 3 5 3 2
50 5 0 5 4 0 4
53 7 3 4 3 0 3
55 8 5 3 2 0 2
57 9 7 2 0
60 101/2 10 1/2 1/2 0 l/2
70 193/4 20 -1/4 * 1/4 0 1/4
* A deeply in-the-money option may actually trade at a discount from intrinsic value in advance of
expiration.
of its options, both puts and calls. Moreover, the marketplace may at any time value
options at a higher or lower volatility than the underlying stock actually exhibits.
This is called implied volatility, as distinguished from actual volatility. Also, the put
option is usually worth at least its intrinsic value at any time, and should be worth
exactly its intrinsic value on the day that it expires. Figure 15-1 shows where one
might expect the XYZ July 50 put to sell, for any stock price, if there are 6 months
remaining until expiration. Compare this with the similar pricing curve for the call
option (Figure 15-2). Note that the intrinsic value line for the put option faces in
the opposite direction from the intrinsic value line for call options; that is, it gains
value as the stock falls below the striking price. This put option pricing curve
demonstrates the effect mentioned earlier, that a put option loses time value pre
mium more quickly when it is in-the-money, and also shows that an out-of-the
money put holds a great deal of time value premium.
THE EFFECT OF DIVIDENDS ON PUT OPTION PREMIUMS
The dividend of the underlying stock is a negative factor on the price of its call
options. The opposite is true for puts. The larger the dividend, the nwre valuable the
puts will be. This is true because, as the stock goes ex-dividend, it will be reduced in
Cl,opter 15: Put Option Basics
FIGURE 1 5-1.
Put option price curve.
~
it
C:
.Q
a.
0
FIGURE 1 5-2.
Call option price curve.
~
ct
C:
0
11
10
9
8
7
6
a 5
Striking
Price (50)
Greatest
Value for
Time Value
Stock Price
0 4 ----------------------
3
2
1
0
40 45
represents the option's
time value premium. ________ L ________ _
50\ 55 60 Stock Price Intrinsic value
remains at zero
until striking price
is passed.
249
price by the amount of the dividend. That is, the stock will decrease in price and
therefore the put will become more valuable. Consequently, the buyer of the put will
be willing to pay a higher price for the put and the seller of the put will also demand
a higher price. As with listed calls, listed puts are not adjusted for the payment of cash
dividends on the underlying stock. However, the price of the option itself will reflect
the dividend payments on the stock.
250 Part Ill: Put Option Strategies
Example: XYZ is selling for $25 per share and will pay $1 in dividends over the next
6 months. Then a 6-month put option with strike 25 should automatically be worth
at least $1, regardless of any other factor concerning the underlying stock. During the
next 6 months, the stock will be reduced in price by the amount of its dividends- $1
- and if everything else remained the same, the stock would then be at 24. With the
stock at 24, the put would be 1 point in-the-money and would thus be worth at least
its intrinsic value of 1 point. Thus, in advance, this large dividend payout of the
underlying stock will help to increase the price of the put options on this stock.
On the day before a stock goes ex-dividend, the time value premium of an in
the-money put should be at least as large as the impending cash dividend payment.
That is, if XYZ is 40 and is about to pay a $.50 dividend, an XYZ January 50 put should
sell for at least l 0½. This is true because the stock will be reduced in price by the
amount of its dividend on the day of the ex-dividend.
EXERCISE AND ASSIGNMENT
When the holder of a put option exercises his option, he sells stock at the striking
price. He may exercise this right at any time during the life of the put option. When
this happens, the writer of a put option with the same terms is assigned an obligation
to buy stock at the striking price. It is important to notice the difference between
puts and calls in this case. The call holder exercises to buy stock and the call writer is
obligated to sell stock. The reverse is true for the put holder and writer.
The methods of assignment via the OCC and the brokerage firm are the same
for puts and calls; any fair method of random or first-in/first-out assignment is
allowed. Stock commissions are charged on both the


he difference between
puts and calls in this case. The call holder exercises to buy stock and the call writer is
obligated to sell stock. The reverse is true for the put holder and writer.
The methods of assignment via the OCC and the brokerage firm are the same
for puts and calls; any fair method of random or first-in/first-out assignment is
allowed. Stock commissions are charged on both the purchase and sale of the stock
via the assignment and exercise.
When the holder of a put option exercises his right to sell stock, he may be sell
ing stock that he currently holds in his portfolio. Second, he may simultaneously go
into the open market and buy stock for sale via the put exercise. Finally, he may want
to sell the stock in his short stock account; that is, he may short the underlying stock
by exercising his put option. He would have to be able to borrow stock and supply
the margin collateral for a short sale of stock if he chose this third course of action.
The writer of the put option also has several choices in how he wants to handle
the stock purchase that he is required to make. The put writer who is assigned must
receive stock. (The call writer who is assigned delivers stock.) The put writer may cur
rently be short the underlying stock, in which case he will merely use the receipt of
stock from the assignment to cover his short sale. He may also decide to immediate-
0.,ter 15: Put Option Basics 251
ly sell stock in the open market to offset the purchase that he is forced to make via
the put assignment. Finally, he may decide to retain the stock that is delivered to him;
he merely keeps the stock in his portfolio. He would, of course, have to pay for ( or
margin) the stock if he decides to keep it.
The mechanics as to how the put holder wants to deliver the stock and how the
put writer wants to receive the stock are relatively simple. Each one merely notifies
his brokerage firm of the way in which he wants to operate and, provided that he can
meet the margin requirements, the exercise or assignment will be made in the
desired manner.
ANTICIPATING ASSIGNMENT
The writer of a put option can anticipate assignment in the same way that the writer
of a call can. When the time value premium of an in-the-money put option disappears,
there is a risk of assignment, regardless of the time remaining until expiration. In
Chapter 1, a form of arbitrage was described in which market-makers or firm traders,
who pay little or no commissions, can take advantage of an in-the-money call selling
at a discount to parity. Similarly, there is a method for these traders to take advantage
of an in-the-money put selling at a discount to parity.
Example: XYZ is at 40 and an XYZ July 50 put is selling for 9¾ a ¼ discount from
parity. That is, the option is selling for ¼ point below its intrinsic value. The arbi
trageur could take advantage of this situation through the following actions:
1. Buy the July put at 9¾.
2. Buy XYZ common stock at 40.
3. Exercise the put to sell XYZ at 50.
The arbitrageur makes 10 points on the stock portion of the transaction, buying the
common at 40 and selling it at 50 via exercise of his put. He paid 9¾ for the put
option and he loses this entire amount upon exercise. However, his overall profit is
thus ¼ point, the amount of the original discount from parity. Since his commission
costs are minimal, he can actually make a net profit on this transaction.
As was the case with deeply in-the-money calls, this type of arbitrage with
deeply in-the-money puts provides a secondary market that might not otherwise
exist. It allows the public holder of an in-the-money put to sell his option at a price
near its intrinsic value. Without these arbitrageurs, there might not be a reasonable
secondary market in which public put holders could liquidate.
252 Part Ill: Put Option Strategies
Dividend payment dates may also have an effect on the frequency of assign
ment. For call options, the writer might expect to receive an assignment on the day
the stock goes ex-dividend. The holder of the call is able to collect the dividend by
so exercising. Things are slightly different for the writer of puts. He might expect
to receive an assignment on the day after the ex-dividend date of the underlying
stock. Since the writer of the put is obligated to buy stock, it is unlikely that any
one would put the stock to him until after the dividend has been paid. In any case,
the writer of the put can use a relatively simple gauge to anticipate assignment near
the ex-dividend date. If the time value premium of an in-the-money put is less than
the amount of the dividend to be paid, the writer may often anticipate that he will
be assigned immediately after the ex-dividend of the stock. An example will show
why this is true.
Example: XYZ is at 45 and it will pay a $.50 dividend. Furthermore, the XYZ July 50
put is selling at 5¼. Note that the time value premium of the July 50 put is ¼ point
- less than the amount of the dividend, which is ½ point. An arbitrageur could take
the following actions:
1. Buy XYZ at 45.
2. Buy the July 50 put at 5¼.
3. Collect the ½-point dividend (he must hold the stock until the ex-date to collect
the dividend).
4. Exercise his put to sell XYZ at 50 ( writer would receive assignment on the day
after the ex-date).
The arbitrageur makes 5 points on the stock trades, buying XYZ at 45 and selling it
at 50 via exercise of the put. He also collects the ½-point dividend, making his total
intake equal to 5½ points. He loses the 5¼ points that he paid for the put but still
has a net profit of ¼ point. Thus, as the ex-dividend date of a stock approaches, the
time value premium of all in-the-money puts on that stock will tend to equal or exceed
the amount of the dividend payment.
This is quite different from the call option. It was shown in Chapter 1 that the
call writer only needs to observe whether the call was trading at or


that he paid for the put but still
has a net profit of ¼ point. Thus, as the ex-dividend date of a stock approaches, the
time value premium of all in-the-money puts on that stock will tend to equal or exceed
the amount of the dividend payment.
This is quite different from the call option. It was shown in Chapter 1 that the
call writer only needs to observe whether the call was trading at or below parity,
regardless of the amount of the dividend, as the ex-dividend date approaches. The
put writer must determine if the time value premium of the put exceeds the amount
of the dividend to be paid. If it does, there is a much smaller chance of assignment
because of the dividend. In any case, the put writer can anticipate the assignment if
he carefully monitors his position.
O.,ter 15: Put Option Basics
POSITION LIMITS
253
Recall that the position limit rule states that one cannot have a position of more than
the limit of options on the same side of the market in the same underlying security.
The limit varies depending on the trading activity and volatility of the underlying stock
and is set by the exchange on which the options are traded. The actual limits are
13,500, 22,500, 31,500, 60,000, or 75,000 contracts, depending on these factors. One
cannot have more than 75,000 option contracts on the bullish side of the market - long
calls and/or short puts - nor can he have more than 75,000 contracts on the bearish
side of the market - short calls and/or long puts. He may, however, have 75,000 con
tracts on each side of the market; he could simultaneously be long 75,000 calls and
long 75,000 puts.
For the following examples, assume that one is concerned with an underlying
stock whose position limit is 75,000 contracts.
Long 75,000 calls, long 75,000 puts - no violation; 75,000 contracts bullish (long
calls) and 75,000 contracts bearish (long puts).
Long 38,000 calls, short 37,000 puts - no violation; total of 75,000 contracts bullish.
Long 38,000 calls, short 38,000 puts - violation; total of 76,000 contracts bullish.
Money managers should be aware that these position limits apply to all "related"
accounts, so that someone managing several accounts must total all the accounts'
positions when considering the position limit rule.
CONVERSION
Many of the relationships between call prices and put prices relate to a process
known as a conversion. This term dates back to the over-the-counter option days
when a dealer who owned a put ( or could buy one) was able to satisfy the needs of a
potential call buyer by "converting" the put to a call. This terminology is somewhat
confusing, and the actual position that the dealer would take is little more than an
arbitrage position. In the listed market, arbitrageurs and firm traders can set up the
same position that the converter did.
The actual details of the conversion process, which must include the carrying
cost of owning stock and the inclusion of all dividends to be paid by the stock during
the time the position is held, are described later. However, it is important for the put
option trader to understand what the arbitrageur is attempting to do in order for him
to fully understand the relationship between put and call prices in the listed option
market.
254 Part Ill: Put Option Strategies
A conversion position has no risk. The arbitrageur will do three things:
1. Buy 100 shares of the underlying stock.
2. Buy 1 put option at a certain striking price.
3. Sell l call option at the same striking price.
The arbitrageur has no risk in this position. If the underlying stock drops, he can
always exercise his long put to sell the stock at a higher price. If the underlying stock
rises, his long stock offsets the loss on his short call. Of course, the prices that the
arbitrageur pays for the individual securities determine whether or not a conversion
will be profitable. At times, a public customer may look at prices in the newspaper
and see that he could establish a position similar to the foregoing one for a profit,
even after commissions. However, unless prices are out of line, the public customer
would not normally be able to make a better return than he could by putting his
money into a bank or a Treasury bill, because of the commission costs he would pay.
Without needing to understand, at this time, exactly what prices would make an
attractive conversion, it is possible to see that it would not always be possible for the
arbitrageur to do a conversion. The mere action of many arbitrageurs doing the same
conversion would force the prices into line. The stock price would rise because arbi
trageurs are buying the stock, as would the put price; and the call price would drop
because of the preponderance of sellers.
When this happens, another arbitrage, known as a reversal ( or reverse conver
sion), is possible. In this case, the arbitrageur does the opposite: He shorts the under
lying stock, sells 1 put, and buys 1 call. Again, this is a position with no risk. If the
stock rises, he can always exercise his call to buy stock at a lower price and cover his
short sale. If the stock falls, his short stock will offset any losses on his short put.
The point of introducing this information, which is relatively complicated, at
this place in the text is to demonstrate that there is a relationship between put and
call prices, when both have the same striking price and expiration date. They are not
independent of one another. If the put becomes "cheap" with respect to the call, arbi
trageurs will move in to do conversions and force the prices back in line. On the other
hand, if the put becomes expensive with relationship to the call, arbitrageurs will do
reversals until the prices move back into line.
Because of the way in which the carrying cost of the stock and the dividend rate
of the stock are involved in doing these conversions or reversals, two facts come to
light regarding the relationship of p


versions and force the prices back in line. On the other
hand, if the put becomes expensive with relationship to the call, arbitrageurs will do
reversals until the prices move back into line.
Because of the way in which the carrying cost of the stock and the dividend rate
of the stock are involved in doing these conversions or reversals, two facts come to
light regarding the relationship of put prices and call prices. Both of these facts have
to do with the carrying costs incurred during the conversion. First, a put option will
generally sell for less than a call option when the underlying stock is exactly at the
striking price, unless the stock pays a large dividend. In the older over-the-counter
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 a large sup
ply of both listed puts and calls is available through the OCC. Arbitrageurs again
serve a useful 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 a put
option will lose its time value premium much more quickly in-the-money than a call
option will (and, conversely, a put option will generally hold out-of-the-money time
value premium better than a call option will). Again, the conversion and reversal
processes play a large 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.
Put Option Buying
The purchase of a put option provides leverage in the case of a downward move by
the underlying stock. In this manner, it is an alternative to the short sale of stock,
much as the purchase of a call option is a leveraged alternative to the purchase of
stock.
PUT BUYING VERSUS SHORT SALE
In the simplest case, when an investor expects a stock to decline in price, he may
either short the underlying stock or buy a put 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 a stock 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 a put purchase is for specu
lative purposes when expecting a price decline in the underlying stock.
These results for the profit or loss of the put option purchases can be compared
to a similar 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
Gopter 16: Put Option Buying
TABLE 16-1.
Results of put purchase at expiration.
XYZ Price ot Put Price ot
Expiration Expiration
20
30
40
45
48
50
60
70
FIGURE 16-1.
Put option purchase.
30
20
10
5
2
0
0
0
Stock Price at Expiration
257
Put Option
Profit
+$2,500
+ 1,500
+ 500
0
300
500
500
500
ifled from Table 16-2 and Figure 16-1. If the stock drops in price sufficiently far, the
percentage profits are much greater on the put option purchase than they are on the
short sale of the underlying stock. This is the leveraging effect that an option pur-
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 a lim
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 a put 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 buy


0 (+ 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 a speculative 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-
G,pter 16: Put Option Buying 259
ly, the percentage returns from having purchased a cheaper, 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 a
put 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 a substantial 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 a call that is going into-the-money.
Example: If XYZ fell by 5 points to 44, definitely a move in the put buyer's favor, 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
a very 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
260 Part Ill: Put Option Strategies
buyer can often purchase a longer-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
a trading 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 a loss,
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 a fixed amount (generally considered to be one point, for simplicity). Thus,
if XYZ is at 49 and a call option is priced at 3 with a delta 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
O.,ter 16: Put Option Buying 261
changes even on a fractional 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 a put is a negative number, reflecting the fact that the put price and the stoc


ct the
call to sell for 3½ with XYZ at 50 and to sell at 2¼ with XYZ at 48. In reality, the delta
O.,ter 16: Put Option Buying 261
changes even on a fractional 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 a put is a negative 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 a put ranges between O and minus 1. If a July 50 put has a delta of
-½, and the underlying stock rises by 1 point, the put will lose ½ point. The delta of
a deeply out-of-the-money put is close to zero. The put's delta 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 a value 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, a method 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 a more 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 a fixed 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 a more conservative list of put purchases.
262 Part Ill: Put Option Strategies
As was stated earlier, it is necessary to have a computer to make an accurate analysis
of all listed options. The average customer is forced to obtain such data from a bro
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 a fixed 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 a realistic
assumption. There are enough reliable and sophisticated data services that one
should not have to work with inferior analyses in today's option 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 a
losing situation. Before discussing these specific strategies, it should be stated again
that it is rarely to the option buyer's benefit 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 a prohibitive move. This is true even ifhe has to accept a price
that is a slight discount from parity when he sells his option.
LOCKING IN PROFITS
The reader may recall that there were four strategies (perhaps "tactics" is a better
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, a fifth strategy
can be employed when a stock has both listed puts and calls.
After an underlying stock has moved down and the put buyer has a relatively
substantial unrealized gain, he might consider taking one of the following actions:
1. Sell the put and liquidate the position for a profit.
2. Do nothing and continue to hold the put.
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 a spread 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 a listed put who has an unrealized profit might
consider buying a listed call to protect his position.
Example: A speculator 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 a position to
implement one of these five


older of a listed put who has an unrealized profit might
consider buying a listed call to protect his position.
Example: A speculator 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 a position 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 a profit 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 a loss at expiration.
These two simple strategies - liquidating or doing nothing are the easiest
alternatives. The remaining strategies allow one to attempt to achieve a balance
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
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's initial 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 a spread by selling the
October 45 put against the October 50 that he currently holds. This would create a
bear 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's risks 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. (A put
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 a call 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 C b' d t 5 . t
l O b 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
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 a relatively dramatic move either up or down by expiration. The
strategy of simultaneously owning both a put and a call 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 a different
set of circumstances. The ultimate result of


c move either up or down by expiration. The
strategy of simultaneously owning both a put and a call 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 a different
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 a profit 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 a lower strike.
4. "Spread" - create a spread by selling the out-of-the-money put against the put
already held.
5. "Combine" create a combination by buying a call at a lower 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
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 B denotes best tactic and
W denotes 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 a profitable long position in order to take some profits, and con
tinue to hold the remainder.
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 a distinctly bullish stance, it
is not always the wisest thing to do. The put holder who has a loss may also consider
either "rolling up" to create a bearish spread or entering into a calendar spread.
Either of these actions could help him recover part or all of his loss.
THE "ROLLING-UP" STRATEGY
The reader may recall that a similar action to "rolling up," termed "rolling down," was
available for call options held at a loss and was described in Chapter 3. The put buyer
who owns a put at a loss may be able to create a spread that allows him to break even
at a more favorable price at expiration. Such action will inevitably limit his profit
potential, but is generally useful in recovering something from a put 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 a later 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 a put 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 a position 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.


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 a spread ( technically, a bear
spread). He has spent no additional money, except commissions, to set up this spread,
since the sale of the October 45's covered 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.
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's for 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
a small 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, a substantial 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 a
large 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 a total loss. He gener
ally would be appreciative of getting out even or of making a small 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
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
a spread 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 a small debit or, preferably, at even money (zero debit).
The spread position offers a much 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 a significant
amount. Using this spread strategy for puts would require a margin 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 a calendar 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, a loss 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 a loss
equal to his commissions plus the initial unrealized loss. In the example above, ifXYZ
dropped quickly back to 45, the July 45 might be wo


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 a loss
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 a loss 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
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 a loss 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 a loss 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 a loss even if the stock declines makes it a less 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 a call, is equivalent to the purchase of a put. That is, both
have a limited 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 a previously 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.
Put Buying in Conjunction
with Com.m.on Stock
Ownership
Another useful feature of put options, in addition to their speculative leverage in a
downward move by the underlying stock, is that the put purchase can be used to limit
downside loss in a stock that is owned. When one simultaneously owns both the com
mon stock and a put on that same stock, he has a position with limited downside risk
during the life of the put. This position is also called a synthetic long call, because the
profit graph is the same shape as a long 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
a finite 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 a holding 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 a burden that cost a small por
tion of potential profits. This strategy, however, is not necessarily geared to maximizing
211
272 Part Ill: Put Option Strategies
TABLE 17-1.
Results at expiration on a protected 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.
X
w
1i'i $0 Cf)
Cf)
0 ..J
c5
e
0.
-$400
,
, , ,
Long ,'
Stock ,,
,, ,,
, , ,
48 50 ,'52
, ,, ,
,, ,
,
, ,, ,
, , ,,
Stock Price at Expiration
,, ,,
,, ,,
, ,
Total
Profit
-$ 400
400
400
0
+ 600
+ 1,600
+ 2,600
one's profit 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 a short-term horizon. Second, the buyer of common stock who wants some
"insurance" in case he is wrong may also find the put protection attractive.
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


y utilize the put protection to limit losses
over a short-term horizon. Second, the buyer of common stock who wants some
"insurance" in case he is wrong may also find the put protection attractive.
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 a put will limit the stockholder's downside risk while still allowing room for upside
appreciation. A large number of individual and institutional investors have holdings
that they might find difficult to sell for one reason or another. The purchase of a low
cost put can often reduce the negative effects of a bear market on their holdings.
The second general class of put buyers for protection includes the investor who
is establishing a position in the stock. He might want to buy a put at the same time
that he buys the stock, thereby creating a position with profitability as depicted in the
previous profit graph. He immediately starts out with a position 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 a temporary setback. Some fairly aggressive stock traders
use this technique because it eliminates the necessity of having to place a stop loss
order on the stock. It is often frustrating to see a stock fall and touch off one's stop
loss limit order, only to subsequently rise in price.' The stock owner who has a put for
protection need not overreact to a downward 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 a hindrance on profit
potential if the underlying stock rises in price. Unfortunately, the put's protective 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 a deeply out-of-the-money put as
protection is more like "disaster insurance": It will prevent a stock owner from expe
riencing a disaster in terms of a downside loss during the life of the put, but will not
provide much protection in the case of a limited 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.
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 a
profit. However, the in-the-money put provides vast quantities of downside protec
tion, limiting his loss to a very 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 a maximum 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 a
good strategy. On the other hand, it is not wise to purchase a put that is too deeply
out-of-the-money as protection. Generally, one should purchase a slightly out-ofthe
money put as protection. This helps to achieve a balance 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 a common stock holding (Figure 17-1). It has exactly the
same shape as the profit graph of a simple 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 a call differs sub
stantially from the ownership of common stock and a put. 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 p


s 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.
G,pter 17: Put Buying in Conjunction with Common Stock Ownership
TAX CONSIDERATIONS
275
Although tax considerations are covered in detail in a later chapter, an important tax
law concerning the purchase of puts against a common stock holding should be men
tioned at this time. If the stock owner is already a long-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 a hedge, there is no effect on the tax status of his stock. However, if one
Is currently a short-tenn holder of the common stock at the time that he buys a put,
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, a stock owner
must own the stock for 6 months before it can be considered a long-term capital gain.
An investor who bought the stock and held it for 5 months and then purchased a put
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 a tax advisor
if he is in doubt as to the effect that a put 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 a call 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
a little, 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 a protective collar or, more sim
ply, a "collar." (It is also called a "hedge wrapper," although that is an outdated term.)
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 a
profit. However, the in-the-money put provides vast quantities of downside protec
tion, limiting his loss to a very 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 a maximum 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 a
good strategy. On the other hand, it is not wise to purchase a put that is too deeply
out-of-the-money as protection. Generally, one should purchase a slightly out-ofthe
nwney put as protection. This helps to achieve a balance 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 a common stock holding (Figure 17-1). It has exactly the
same shape as the profit graph of a simple 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 a call differs sub
stantially from the ownership of common stock and a put. 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 sligh