Targeting a "Lower Purchase Price"

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 of an equity put option assumes the obligation of purchasing 100 shares of the underlying stock at the strike price. In return for assuming this obligation, the put seller receives the premium that is paid by the purchaser.

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.

Ratio spreads involve the purchase of one quantity of one option and the sale of a different quantity of a second option of the same type, with the same underlying and same expiration but with a different strike price. The ability to enter into ratio spreads requires special approval from your firm. Clients must be approved to trade spreads and approved to trade either uncovered or cash-secured puts. Make sure that your client's paperwork and approval forms are completed.

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.

At expiration, there are three possible outcomes. The XYZ stock can be at or above 70, the higher strike; between 70 and 65; or it can be below 65. If the stock price is at or above the higher strike at expiration, then all puts expire worthless, and the full amount paid for the position is lost.

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?"

The ratio vertical put spread, in this example, is really two positions, a purchased 70-65 Put spread and a short 65 Put. At or below the strike of 65, the 70-65 put spread will reach its maximum value of $5 per share, and the short 65 Put will be assigned. Since the position was established at a net cost of zero in this example, the $5 value of the put spread is all profit, and the effective purchase price of XYZ stock for the short 65 put is equal to $65. Consequently, subtracting the $5 profit from the put spread from the $65 stock price lowers the final effective purchase price to $60. And that was the client's goal.

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

If your client wants to purchase stock below the current market price, and if you can't find a put that targets the desired effective purchase price, then a ratio vertical spread with puts may be a desirable alternative.

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.