Chapter 23
A Primer On Put Options
Compared to the bear market mutual funds I just told you about in the previous chapter, put options offer some great advantages (but also some disadvantages).Advantage #1. As with the mutual funds, when you buy options, you can never lose more than you invest. You could lose everything you put into them, but never a penny more. No matter what happens, you are 100% protected from losses that could threaten any funds or assets you have invested elsewhere.
Advantage #2. On average, you can get more leverage. The reason is that, with the mutual funds, only a portion of your money is allocated to bear market strategies. Even the most aggressive mutual fund is designed to give you a 20% return for every 10% decline in the market. Depending on the options you choose, you could make 50% or even 100% from a 10% market decline.
Advantage #3. You can invest in options with a lot less money. The mutual funds I told you about typically have minimums of $25,000. Even if you buy through a broker in lesser amounts, the minimum investment will be $500 to $1,000. However, you can find options that cost as little as $100.
Warning: If you are investing a substantial portion of your savings on options, you may be taking excessive risk.
Now for the disadvantages ...
Disadvantage #1. More leverage is a double-edged sword. If your put option can make you a 100% profit on a 10% decline, it means you could also wind up with nearly a wipe-out loss if the market rises 10%.
Disadvantage #2. Unlike your mutual fund shares, put options have an expiration date. This means the market decline needs to take place before they expire.
Disadvantage #3. If they're short term, put options can be very volatile and should be watched daily, even hourly. But long-term options are much more manageable. So if you're doing this on your own and don't have the time to track them closely, I recommend you stick primarily with LEAPS, which are the long-term variety of put options.
Options: A Guided Tour
Stacked up beside me on the floor is a pile of recent and classic books on the subject of options. Almost every single author promises to make options "easy." But I can't find even one who fulfills that promise. For some mysterious reason, these experts just love to dazzle you with facts and confuse you with terminology.This is truly unfortunate. Options are investments that can make you a fortune from the Great Stock Panic ... yet they are the least understood by investors, simply because no one has taken the time to explain options in terms that actually make sense.
For starters, forget about learning a whole bunch of complex options strategies. Instead, let's just dive straight into some practical examples ...
You walk into the office of your local real estate broker ...
He takes you out to see a beautiful house in a great neighborhood. The price is good too. But you're not quite ready to buy. You consider renting � just to try it out.
You meet the seller and he says: "OK. I'll rent you my house with an option to buy."
You like that and you hash out the terms. The going price for similar homes is roughly $280,000. But everyone agrees that prices in the area are going up. So the seller says he'll give you an option to buy the house at $285,000.
The term is 12 months. If you don't exercise the option within that time frame, that's it. You've lost your chance. You figure: You need a place to live anyhow. The option is the icing on the cake. If you don't use it, you've lost nothing. If you need it, you've got it. So you accept the deal. A few weeks later ...
You get a call from
a headhunter offering
you a new job ....
He offers you better pay. Your response: "No." He offers you all kinds of great benefits. "Still not interested." But then he starts telling you about stock options, and you suddenly find yourself paying closer attention.
"Here's the deal," he says with genuine excitement. "This is one of those up-and-coming, high-tech, companies with incredible growth potential that has found low-cost cracker-jack programmers all over the world. Similar companies with lesser products have recently gone absolutely, totally berserk in the stock market.
"One such company first offered its shares for $2 and zoomed to $98 per share. Another was worth just $10,000 not too long ago and is now worth more than Boeing Aircraft. Just as a welcome-aboard bonus, this company will give you an option to buy 10,000 of its shares at $5 anytime within the next five years. That's a pretty good strike price � $5.
"The stock is selling for $2.75 right now. So you can't do anything with the options at this particular moment. But you just wait. This stock is headed for $10, $20, maybe even $50 � just like those other high-tech stocks. When that happens, you can cash in � big time! No matter what the shares are selling at, you still get to buy at $5.
"Let's be conservative," he continues. "Let's say the stock only reaches $10. In effect, you go in there and you buy the 10,000 shares for $5 buck a pop. That's $50,000. Then, you turn right around and sell them for $100,000. Bingo! You've bagged a hefty $50,000 profit."
The headhunter pauses and then says: "This is how CEOs have become multi-millionaires in recent years. This is how thousands of managers have transformed themselves from hired hands into owners of some of the nation's richest companies. Now I'm giving you the opportunity to do the same."
You call your broker for some advice. He thinks it's a good deal for several reasons.
First, even if all their promises fall by the wayside, you've lost nothing by accepting the option. When you hold an option, it means you decide whether to buy or not. If it turns out the company is a total flop, you throw it in the trashcan. You don't lose a penny.
Second, unlike options you buy from your broker, this option doesn't cost you diddly-squat. The company is offering to give it to you � free. If you wanted to buy similar options in the stock market, you'd have to pay for the privilege, especially with any option that gives you so much time. Some options are extremely cheap. But no one in the market ever gives them away.
Still, you want to negotiate a better deal. You call back and you say: "I want more time � 10 years instead of five. Plus, I want a lower strike price � $3 instead of $5."
The headhunter's answer is immediate: "No way! An option to buy at $3, like you're asking for, would be too valuable to give away. If the stock goes up just 25 cents, to $3, you'd already be at the money. If the stock goes up just 50 cents, to $3.25, you'd already be 25 cents in the money. Plus, you'd have a full 10 years for this to happen.
"Heck, in 10 years, this stock could be worth 100 bucks! Then you'd buy it for $3, sell it for $100, and take out a $97 profit on each share. Multiply that by 10,000 shares � and you've got close to a million. There's no way this company is going to give away that much."
You hang up and forget about the whole thing. But it wasn't a waste of time. Because without realizing it ...
You've just learned most of
what you will need to know
about options!
You've learned what the expiration is � when the option expires, of course ...
You've learned concepts like "at the money" (when the market is at the same level as the strike price) ... and "in the money" (when the market has surpassed the strike price).
More important, you've learned some basic rules:
1. The closer the current share price is to the option's strike price, the better the chance of reaching the strike price in the allotted time � and the more valuable the option is.
2. The more time you get, the more an option is worth.
3. The pay-off can be huge. But the risk is limited. You can never lose more than what you pay for it.
These same principles apply to put options. The main difference: Put options are designed to profit when prices go down � ideal for the Great Stock Panic. And just as call options created instant millionaires when the market was booming, put options can create instant millionaires when the market busts.
It's very simple. Instead of giving you the right to buy at a predetermined price, the put options give you the right to sell the stock at that price.
For example, let's say you expect the shares in ABC company to drop from $100 to $50. You can buy a put option � the right sell the stock � for $90.
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When the share price drops to $50, you can buy it for $50, then your option lets you sell it for $90 � giving you a profit of $40.
For a better idea of how this works, let's give it a whirl with some "play" money. Consider this contract ...
Here are the specifics on the put option contract in the accompanying box.
Plus, as you may have noticed ...
You don't have to exercise the option to get your money out of it. You can sell it on the open market anytime before expiration.
In fact, I don't recommend you exercise options at all. Reason: The goal here is to make a profit by buying and selling the options � not by owning or selling short the stocks.
This makes life a lot simpler. All you want to do is buy them low and sell them high. Just like a stock or any other security you regularly invest in.
Now, consider these questions ...
- How much would you pay for this particular option?
- How much could you sell it for?
- How much could you lose?
- How much profit could you make?
First, how much do you have to pay for it? That's easy. You can just ask your broker, check the newspaper or the Internet: Lets say the ABC put option is going for $5 per share. Since all options are for 100 shares, that means it costs 100 x 5 or $500 per contract.
How much could you sell it for? Let's go through some scenarios ...
The "Oops!" Scenario
You just happen to buy at exactly the wrong time. Instead of falling as you expected, ABC shares start going up immediately to $130. Now, the $90 strike price, which seemed to be within easy reach when you bought it, is farther away. Meanwhile, time just keeps ticking by.|
Put Option Contract (P.S. I don't have to exercise this contract. I can sell it to someone else for whatever they're willing to pay for it.) |
But look at the positive side. If you had sold short 100 shares of ABC (like Dad would have done in the 1930s), you'd have a loss of $30 per share, or $3,000; and with 50% margin, you could have sold 200 shares, and you'd be down $6,000. Worse, the more ABC goes up, the more you'd lose.
Not so with options! Even in this worst-case scenario, all you've lost is the $500 you invested, plus a small commission. No matter how far ABC rises, that's the most you could ever lose.
The "Nowhere" Scenario
ABC goes down a small fraction one day, up a bit the next day. But despite some excitement here and there, it always seems to wind up pretty much in the same spot.With every day that passes, your option goes down in value. It reminds you of an hourglass dropping grains of sand with each passing moment.
Suddenly, in the last few days before your option expires, ABC finally falls a few points. But it's too late. The stock doesn't fall below $90 until three weeks after your put option expires.
The irony is that you were right about ABC � it did go up just like you thought it would. But that's not good enough. You also had to be right about the timing. You bought the put option too soon. By the time the shares really started to fall, your time ran out. End result: The option expires worthless (same as the "Oops!" scenario).
The "Break-Even" Scenario
ABC falls apart right out of the starting gate. Your timing is perfect. And it continues to tumble nearly every day. The stock falls below $90, you're "in the money" and you're delighted.But "in the money" does not necessarily mean in the profits. Remember, you paid $5 per share or $500 for the contract. So by expiration time, for you to break even, ABC not only has to fall below the strike price of $90, it has to fall beyond it by $5 � to $85.
And that's exactly what happens. If you exercised the option at that point, you'd sell 100 shares of ABC for $90 per share. And you'd be able buy them for $85 per share, netting you $5 per share.
For 100 shares, that's $500 � exactly what you invested in this deal in the first place. You make nothing and lose nothing, except some commissions, of course.
The "Double-Your Money" Scenario
Like in the previous scenario, ABC falls sharply right out of the box. Within a few weeks, it reaches the strike price of $90. Within a few months, it falls through the $85 level, which would be the break-even point at expiration. But we're still weeks away from expiration, and ABC continues to fall.At expiration, ABC is trading at $80. If you exercised your option, you'd be able to sell short the 100 shares of ABC for $90 and immediately buy them back for $80 each. That's a nice $10 difference, or $1,000.
But you don't exercise the option. Instead, you just sell it to someone else for the $1,000. You never have to exercise � you can always sell your option to close your position.
Not bad. You go in with $500 and walk away with $1,000 � double your money, or a 100% profit. For investors used to stocks and bonds, this may sound like a fantastic result. But, with the purchase of options, a small move in the stock can double your money.
The "Home Run" Scenario
ABC just keeps plunging, practically nonstop. It falls below the $90 level in the first week. So almost immediately, your option is "in the money." This is a very good sign. Then in the second week, ABC falls below $85 � your break-even point. And it just keeps crashing.Now, it's selling at $65; and there is still a lot of time remaining. You have two choices:
Choice #1. You can wait till the very last week, in the expectation that ABC will go still lower and you'll make even more.
Choice #2. You can sell your put option now, take your profits and run. In your head, you calculate how much you think it's worth: $90 minus $65. That's $25 "in the money." So you figure it should be worth $25 times 100 shares. That's a nice round $2,500.
You figure if you sell it now, you can walk away with five times your original $500 investment. Not bad at all! You call your broker and ask his advice. To your pleasant surprise, you discover that the put option is actually worth about $1,000 more than you estimated � close to $3,500.
Why? Because the $2,500 you figured is strictly the put option's intrinsic value � the amount someone would profit from the sale of the stock if they exercised the option today.
Now in addition to the intrinsic value, this option still has some time value. There is some time left before it expires, and that time is worth something. In fact, investors feel the time remaining is actually worth quite a bit � an additional $1,000 on top of the $2,500 intrinsic value.
Why is that time worth so much? Because ABC is moving down sharply and steadily every day. Like you, other investors are also assuming this trend will continue, and they're willing to pay the $1,000 for the chance of making those extra bucks.
"That's fine," you say. "Let them have that chance!" You cash out and walk away with $3,500 minus commissions. Subtract the $500 you originally invested, and you have a profit of $3,000 � a gain of 6 to 1.
The "Grand Slam Home Run" Scenario
When you first buy the ABC put option, the stock is pretty quiet. In fact, the market is so quiet, you can practically hear a pin drop at the specialist's desk on the trading floor. With that lack of movement, few people are interested in buying options, and the few who do aren't willing to pay the usual price for them.Their logic is simple: "Even if ABC is trading at $100, and the strike price is only 10 points away (at $90), what good is it? At this rate, it will take a month of Sundays for ABC to fall to $90. In this dead market, you'd be lucky if ABC reaches $95 in a year."
People already holding the ABC put options get discouraged. They try to find someone to take these options off their hands, but there are no takers � except you and a few others. So instead of paying $500 for the option, you pick it up for a song � at only $2 per share or just $200 for the 100-share contract.
Suddenly, ABC announces that it missed Wall Street's earnings expectations by a mile. At the same time, the entire tech sector gets clobbered and comes alive with activity. Instead of moving by just a meager 1/8 of a point or less every day, the stock plunges sometimes (and surges) in leaps and bounds, with huge gyrations of as much as 5 or even 10 points per day.
Within days, ABC is selling for $65. You hurriedly call your broker to find out how much the option is worth. You can hardly believe your ears: It has surged from the $200 you originally paid for it to $4,000.
Why is it worth so much? Three reasons:
First, there's the intrinsic value. You know how to figure that: It's the $90 - $65 = $25, or $2,500 for the contract of 100 shares.
Second, there's the time value. With still two months remaining, that's worth a good deal.
Plus, there is now one more critical factor working in your favor: Volatility. Just as the options lost value when the market went dead, they have now gained tremendous value as the market has had a sudden burst of activity. ABC stock is not just falling in larger increments. It's also gyrating wildly all over the lot � down 10 points in just a few hours of trading, rising 5 points in minutes, then down again soon thereafter.
These gyrations � even if they're sometimes in the wrong direction � make the options far more valuable; and this increased value accrues to your benefit.
Adding together (1) the intrinsic value, (2) the time value, and (3) the volatility factor, your ABC put is now worth the $4,000 or a remarkable 20 times more than you paid for it. An explosive investment return.
Is this possible in the real world? Yes. It actually happens quite frequently � provided you can be in the right place at the right time.
The "Pie-In-The-Sky" Scenario
Everything I just told you about in the "Grand Slam Home Run" scenario takes place.In addition to all those factors, there is one more powerful force that drives your options literally through the roof � demand. Here's the lucky series of events that unfolds:
Some large investors, including major banks, who own hundreds of thousands of shares in ABC, decide they cannot sell their holdings outright. Instead, they rush to buy the very same options you have bought, bidding up the prices dramatically � to $8,000 per contract � 40 times what you paid for it. Impossible? Not at all.
This gives you the full range of possibilities.
Now let's sum up some of the basics ...
- Put options give you the right � but not the obligation � to sell a specific investment at a specific price, within a certain period of time.
If there is no profit, you can just let them expire worthless. The profit potential is virtually unlimited. But the potential loss is always absolutely limited to the amount you invest and never a penny more.
- You have access to two kinds of options � not just options to buy ("call" options), but also options to these sell ("put" options) to profit from a declining market.
- Options are available not only on individual stocks, but also on stock indexes � including the Dow Jones Industrial Average, the S&P; 500, and the S&P; 100. This gives you the opportunity to, in effect, greatly diversify your options over a wide variety of stocks with a relatively small investment.
Therefore, for most investors, I recommend long-term options called LEAPS, which are less volatile and are tracked regularly in the Safe Money Report.
And for those investors who are interested in more aggressive trading, I provide several trading services � by fax and email with regular trading advice using shorter term options.
Here are the basic terms you should know ...
Premium: This is the price you pay for the option. An expensive option has a high premium; a cheap one has a low premium.Strike price: This is the price at which the option lets you buy or sell the underlying stock or stock index. For example, a call option on ABC stock with a strike price of 90 gives you the right to buy 100 shares of ABC at $90. A call option with a strike of 110 gives you the right to buy the 100 shares at $110, and so on. Similarly, a put option on ABC stock with a strike price of 90 gives you the right to sell 100 shares at $90.
Expiration: Remember, the option only gives you the right to buy or sell within a specific period of time. Once that time period is over, the option expires. And if the market has not moved enough, or if it has gone in the opposite direction from what you expected, the option could expire worthless. This information is built into the brief description of the option. As an illustration ....
- A Microsoft January 120 call is an option to buy 100 shares of Microsoft stock at the price of $120, with this option expiring in January.
- A June 800 S&P; 500 Cash Index put is an option to sell one contract of the S&P; 500 Cash Index at 800, with this option expiring in June.
The advantages, however, outweigh the disadvantages in my opinion, and the primary one is absolute risk limitation. When you buy options, you can never lose a penny more than you invest. You always know, ahead of time, exactly how much is at risk. Moreover, most options offer very large leverage. These are investments that truly have the potential to deliver windfall profits, but let you sleep nights.
With these vehicles, I think you have the potential to multiply your wealth by as much as ten times � by 1,000%! But suppose I'm wrong. Or suppose your timing is off. Or suppose you lack the money, the courage � or some combination of both � to take advantage of these opportunities.
Don't fret. Even if you do only one-half as well, or only one-fifth as well, you will still have the opportunity to grow your wealth by up to 1,000% by taking your profits from the Great Stock Panic and reinvesting them in the equally great stock recovery. Just be sure you learn ...
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