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