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