BUYING PUTS IN A FALLING MARKET

BUY PUTS ON DECLINING ISSUES

The average investor makes money in a rising market and loses money in a falling market. A good investor makes money in a rising market and does not lose money in a falling market. A really good investor makes money in both a rising and a falling market

In the post of Tuesday, June 13th, “STOCK MARKET RALLY? WHAT MARKET RALLY?", the Author discussed the strategy of buying inverse mutual funds, funds that rise when market indices fall. The Author discussed RYVNX, an inverse fund that moves 2 times inversely to the NASDAQ index. As the NASDAQ falls, RYNVX goes up.

In this post, we will look at Puts, the other type of option. Like a Call, a Put is a contract. A Put gives someone the right to sell a stock at the strike price (fixed price) on or before the expiration date. For review, lets go through the basics of the option terms again. If you saw this information in the prior post, review it or skip past it.

Common Option Features:
a. Fixed Number of Shares. Nearly all option contracts are traded on options exchanges. These exchanges fix the number of shares covered by an option contract at 100 per contract. If you want an option on more shares, you buy more contracts
b. Fixed Price. This price is called the Strike price. The strike prices are also defined by the exchanges. For most stocks, they are broken out at $5 increments. But low priced stocks and high priced stocks have different increments. So a stock currently trading at $62 per share may have option prices of $50, $55, $60, $65, $70 and $75 available from the options exchange.
c. Fixed Date. This is the expiration date of the option. All stock options sold in the US are “American Style” options and they can be exercised on or before the expiration date. The expiration dates are fixed and are the third Friday of the month. If the third Friday of the month falls on a Holiday, the Thursday before becomes the expiration date.

If a person is the holder or owner of an option, he can exercise the option at anytime up to and including the expiration date. Or he can close out the option position, selling or buying back the option.The Put.

Conceptually, there are two parties to a Put. The Put Seller and the Put Buyer. The Put seller (or writer) obligates himself to buy the stock at the strike price on or before expiration. In return for undertaking this obligation, the Put seller is paid a premium.

The Put Buyer, in exchange for paying a premium, obtains the right to sell the stock at the strike price on or before expiration. Let’s look at an example. We will check back with Tarzan and Jane.Tarzan and Jane. Jane has 100 shares of ICBM. ICBM is currently trading at $55 and Jane is worried that ICBM will fall in price. To protect herself from a fall in the price of ICBM, she buys a Put. She buys a Put with a strike price of $50. The premium on this Put is $1.00, so Jane pays $100 for the Put contract. ($1.00 per share * 100 shares per contract). But Jane is protected. If ICBM falls to $50 or lower, she can exercise the Put and sell her ICBM stock for $50.

Tarzan is a gambler. He needs to pick up some fast money for Boy’s new shoes. He is willing to sell a Put contract on ICBM with a strike price of $50 for $100.[i] If ICBM falls to $50 per share or lower, Tarzan can be exercised and must buy the shares at $50.00 per share.

a. Tarzan Win. If ICBM stays at $55 or goes higher, Tarzan can keep the $100 premium and will not have to buy the stock. Tarzan has some other more advanced option strategies, but we will stay with this straightforward example.
b. Jane Wins. ICBM stock falls on bad earnings warnings to $48. Jane is faced with two choices. If a lot of time remains between now and the Put expiration date, she could wait and see if ICBM rises again. Or she could inform the Options exchange that she wishes to exercise the Put and her shares will be sold for $50.00, despite the fact that ICBM is trading at $48.

Tarzan receives notice that his Put has been exercised. He must buy 100 shares of ICBM for $50 per share, despite the fact that ICBM is trading at $48. Tarzan is out $100. Why not $200, if the difference between the strike price that Tarzan pays is $50 per share and the market price of ICBM is $48? The reason is that Tarzan has already received a premium of $1 per share for the Put he sold. ($50 strike price paid - $48 market price + $1.00 premium received = $1.00 loss per share.)

If all of this sounds confusing, don’t feel alone. Options are difficult for many people to understand in the abstract. But in the next few weeks and months, we will set out some simple option strategies that will aid in their understanding.

NO ELECTRONS WERE HARMED (ALTHOUGH A FEW QUANTUM TUNNELED OUT) IN THE MAKING OF THIS POST FOR THE DESERT OF THE REAL!

[i] This is a risky strategy and Tarzan’s broker will require him to have the money in the account to buy the ICBM shares ($50 per share * 100 shares = $5,000) in case Tarzan’s Put is exercised.