I've been buying and selling stock since childhood but have never shorted or used puts. Let's say there's a stock selling for 65 and I think the company's valuation has gotten way ahead of itself. Let's also say my brokerage firm will sell me a put at 60 for two bucks that is good for 24 months. I buy puts for 10,000 shares and am immediately out of pocket for $20,000. That money is totally gone if the stock stays above 60 and the put option times out 24 months from the purchase date. On the other hand, I'm not out $3.00 or more in dividends during the 24 months like I would be if I shorted the stock. I also have no upside risk like I would have in shorting the stock.
1) I think the stock is going to 35 sometime in the next 24 months. If it does, what is the behind the scenes mechanics of put paying me the difference between 35 and 60? I understand a short. In a short the stock was "sold" at 60 and I am responsible for replacing the stock at a future date as well as paying the dividends. When the putted stock drops down to 35 and I exercise the put, someone has to fork over 25 bucks/share. I assume the somebody will be a large brokerage institution. Can put positions be defaulted?
2) Why don't more people buy puts? There's got to be catch somewhere with my logic.
Thanks in advance for any light or experience you can shine/share on this subject. Also, are there any good books you can recommend that deal with puts, options, calls and shorting?
Answer to Q1:
Your assumption that "a large brokerage house will fork out the difference" is not necessarily true. Just like there are buyers and sellers for stocks , there are buyers and sellers for option contracts as well. A put option is a contract that gives the owner the RIGHT TO SELL STOCK AT THE STRIKE PRICE on or before the expiration date. The moment you buy the $60 put, you are GUARANTEED that you WILL GET $60 per stock, even if the stock goes to 0 or gets delisted. This is because the person (or institution) who sold the put to you is OBLIGATED to buy the underlying stock from you at the strike price anytime on or before the expiration date. So - OWNING A PUT = RIGHT TO SELL and SELLING(SHORTING) a put is an OBLIGATION TO BUY (at the strike price).
Just like there are different people shorting AND going long on a given stock on the SAME day, there are people who will short puts for income, OR buy puts to hedge themselves (depending on their view on the stock) by accepting the risk to buy it at that price no matter what. The reward to the put seller is the $2 premium that you paid him.
SO: Long option positions = RIGHTS (GOOD!)
Short option positions = OBLIGATIONS (RISKY!) . Naked Put Sell positions cannot be defaulted . To ensure this, brokers require minimum margins before allowing traders to short options.
"People dont buy puts" : I am not sure that this is a correct statement. But, lot of us avoid buying puts and options in general because:
a) Lack of thorough knowledge
b) Fear of trading derivatives (due to lack of knowledge!)
c) Time decay
d) The puts are too expensive (i.e. their implied volatility is too high at that time)
Hope that helps!
I haven't achieved anything by buying options, except maybe to identify two reasons why I don't like to:
1. The limited lifetime puts me in a very disadvantaged negotiating position. The pressure to sell for even a relatively small profit is hard to ignore, since the buyers need only wait for expiration. And then the big commissions and the big spreads. All this leads me farther and farther into the money. But so then why bother?
2. The damn things are so flaky that I don't feel I can put much money in each one. And they take a lot of watching. And I tend to get worried and watch the ticker all day. Lots of time spent for relatively little money invested.
I don't know enough to comment on the mechanics of option exercise or the risk that somebody doesn't/can't pay. Buffett recently expressed the opinion that derivative securities in general are no sounder than the entities that back them. So naive or disingenuous "risk management" programs based on these things can fail, backfire, or just cost way too much.
Hi,in a rush but,
if you think the stock will go to 35,look @ the 55 or 50 put,less cash out if wrong. Most out of the money puts expire worthless,I've been SELLING them for 20 years. You can sell the put @ anytime,you don't have to hold it two full years. Is the put liquid,what's the outstanding interest and the spread? You can get f--kd real good on the fills on many options. More later if you need it. WATCH THE COMMISSIONS ON OPTIONS,they will eat you alive at a full service broker,aka,boiler room,like Merrill.Good luck.
Ok, I am admitting I am stupid. Please explain in some detail what you just said below:
"Sell covered calls then use some money to buy puts (current price- money of covered calls= strike price. "
1) What are the tax consequences? Are gains are taxed as ordinary income?
2) If put purchase turns out to be a no return investment, i.e. the investment is lost, can the money spent on puts be deducted as an investment loss?