|XYZ stock is trading at $70, and your client wants to buy it at $60. There are 70-strike and 65-strike puts available, which are trading for $2 and $1, respectively. But there are no 60 puts. Is there something you can do? Yes! Read on. |
Targeting a "Lower Purchase Price"--A Traditional Approach with Short Puts
If the price of the underlying stock closes at or above the strike price of the put at expiration, then the put will expire worthless and the premium received will be kept as income. If the stock price is below the strike price of the put, however, then the put will have value, and its owner will likely exercise the right to sell. The put seller will then be obligated to purchase 100 shares of the stock at the strike price.
The "effective purchase price" of the stock, however, will be equal to the strike price of the put minus the premium received, not including commissions. If a 65-strike put is sold for $1 (per share), for example, and if that put is assigned, then the effective purchase price of the stock is $64, not including commissions.
In the example above, your client can either sell the 70-strike put for $2 or the 65-strike put for $1. If assigned, the 70-strike put results in an effective purchase price for the stock of $68, and the 65-strike put results in an effective purchase price of $64. Neither of these puts meets your client's objective to buy stock at $60. But don't give up hope.
A 1 x 2 ratio vertical spread with puts involves the purchase of put and the sale of two puts with the same underlying and same expiration but with a lower strike price. The term "vertical," when applied to ratio spreads, means that the greater quantity of options is sold.
In this example, one XYZ 70 Put is purchased for 2, or $200, and two XYZ 65 Puts are sold for 1 each, or $100 each. The spread, therefore, is established for a net cost of zero, not including commissions. This trade must be done in a margin account.
If the stock price is below the higher strike but not below the lower strike, then the long put is exercised and the two short puts expire worthless. The result is a short stock position. Since your client's goal was to purchase XYZ stock, not sell it short, then it is likely that your client will want to buy stock to cover the short position.
The desirable outcome, in this example, occurs when the stock price is below the lower strike price of $65. In this case, the long 70 put will be exercised, and the two short 65 puts will be assigned. Consequently, 200 shares of XYZ stock will be purchased (assigned 2 puts) and 100 shares will be sold (exercised 1 put). The net result is that your client will have purchased 100 shares of XYZ stock. The next question is, "what is the effective purchase price?"
Table 1-1 and Graph 1-1 illustrate the profit and loss of the ratio vertical put spread strategy.
Long 1 70 Put @ 2 and Short 2 65 Puts @ 1 each
The risk of a ratio vertical spread with puts is approximately equal to purchasing stock at the effective purchase price. It is, therefore, prudent to make sure your client is committed to purchasing the stock and that there is sufficient cash available.
Please contact a tax advisor for the tax implications involved in this strategy.
Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options. Copies of this document are available from your broker or The Options Clearing Corporation, 400 S. LaSalle Street, Chicago, IL 60605. CBOE and Chicago Board Options Exchange are registered trademarks of the Chicago Board Options Exchange, Incorporated. 2003 Chicago Board Options Exchange, Incorporated, All Rights Reserved.
XYZ stock is trading at $70, and your client wants to buy it at $60. There are 70-strike and 65-strike puts available, which are trading for $2 and $1, respectively. But there are no 60 puts. Is there something you can do? Yes! Read on. Targeting a "Lower Purchase Price"--A Traditional Approach with Short Puts Rather than enter a limit-price order to buy stock below the current market price, the seller