35 lines
2.1 KiB
Plaintext
35 lines
2.1 KiB
Plaintext
Accepting Exposure • 213
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Downside: Overvalued
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Upside: Fairly valued
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Execute: Sell a put contract
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Risk: Strike price minus premium received [same as stock inves-
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tor at the effective buy price (EBP)]
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Reward: Limited to premium received
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Margin: Notional amount of position
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The Gist
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The market is pricing in a relatively high probability that the stock price
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will fall. An investor, from a longer investment time frame perspective,
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believes that the value of the stock is likely worth at least the present mar-
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ket value and perhaps more. The investor agrees to accept the downside
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risk perceived by the market and, in return, receives a premium for doing
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so. The premium cannot be fully realized unless the option expires out-
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of-the money (OTM). If the option expires in-the-money (ITM), the
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investor pays an amount equal to the strike price for the stock but can
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partially offset the cost of the stock by the premium received. The inves-
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tor thus promises to buy the stock in question at a price of the strike
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price of the option less the premium received—what I call the effective
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buy price.
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I think of the short-put strategy as being very similar to buying cor -
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porate bonds and believe that the two investment strategies share many
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similarities. A bond investor is essentially looking to receive a specific
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monetary return (in the form of interest) in exchange for accepting
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the risk of the business failing. The only time a bond investor owns a
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company’s assets is after the value of the firm’s equity drops to zero, and
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the assets revert to the control of the creditors. Similarly, a short-put in-
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vestor is looking to receive a specific monetary return (in the form of an
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option premium) in exchange for accepting the risk that the company’s
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stock will decrease in value. The only time a short-put investor owns a
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company’s shares is after the market value of the shares expires below the
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preagreed strike price.
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Because the strategies are conceptually similar, I usually think of short-
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put exposure in similar terms and compare the “yield” I am generating |