Has a client ever wanted to sell stock short and at the same time wanted to avoid the unlimited upside risk? Some brokers and their clients use the purchase of equity put options instead of selling the stock short to accomplish this objective.
Buyers of put options have the right to deliver the underlying stock, at a predetermined level (the strike price) for a limited period of time (until the option expiration date). The motives of clients who purchase put options believe that the stock could go lower and yet are concerned about upside risk of the stock.
By buying the put, the investor pays the premium while waiting for the stock to decline below the strike price. If the stock does not drop below the strike price by expiration, the premium, plus commission, will be lost by the buyer.
Assume a client tells you he would like to sell 500 shares of XYZ. It is currently priced at 65, but your client feels the stock could reach the level 57 in the next two months. Your client can either place an order to sell 500 shares of XYZ at 65, or buy 5 two-month XYZ puts with a 65-strike price.
Letís compare the two strategies. Commissions and taxes are not considered.
While the long 65 put options to sell stock short at 65 is being held, your client has the right to sell 500 shares at 65. At expiration, the stock will either have stayed above 65 and the investor will not have sold the stock, or it will have traded below 65 and your client can expect to have sold 500 shares at 65.
If your client wishes to sell short 500 shares of XYZ to his portfolio at 65 while the stock is trading at 65, he could buy five of the two month 65 strike price puts at 3.25 each. At expiration, if the stock remained above 65, no stock would be sold short. Your client, however, loses the premium paid of 3.25 x 5 contracts, or $ 1,625. If XYZ is below 65 at expiration, your client has the right to sell short 500 shares at 65. He paid 3.25 when he bought the option, so his net credit is 61.75 per share. Buying the puts lowers the breakeven, which is the strike price minus the premium.
If the stock closes on expiration at 65 or above, the 65 puts will expire worthless. With the purchase of put options, the premium is the only thing that can be lost. If the stock reaches the target price of 57, the options can be exercised or close prior to expiration. Moreover, options on stock are American-style exercise and may be exercised at anytime.
Be aware of margin considerations when buying puts. The minimum margin your firm requires for a put purchase is the full amount of the premium unlike using margin to sell stocks short. Find out what your firmís requirements are.
In summary, buying a put option is a strategy that allows you to pay a premium in return for the right to sell short a particular stock. The premium paid gives you upside protection on a runaway stock but lowers your break-even. This strategy may also give you the opportunity to sell a stock for more than its future level. A client interested in shorting in a stock may want to consider buying a put as a means of selling that stock.
FOR REGISTERED REPRESENTATIVES ONLY. NOT FOR CUSTOMER DISTRIBUTION.
Options are not suitable for every investor. For more information, consult your investment advisor. Prior to buying and selling options, a person must receive a copy of Characteristics and Risks of Standardized Options which is available from your broker or from The Options Clearing Corporation (OCC) by calling 1-888-OPTIONS, or by writing to OCC at One North Wacker Dr. Suite 500, Chicago, IL 60606.