Option Strategy Buy a Put

In the previous section I discussed the use of a Call option in place of buying a stock that you think will increase in value. In this section I will discuss the use of a Put option in place of shorting a stock you think will decrease in value. Most people are familiar with the buy low—sell high logic of buying a stock, that is, buy a stock, it increases in value, and sell it for a profit. Shorting a stock uses a reverse strategy of sell high—buy low. When you short a stock you borrow the stock and sell it at the current market price and then buy it back at a lower price if and when the stock drops in value. There are three issues that you must consider when you short a stock.

1. You must pay interest on the borrowed stock
2. If the stock increases in value you are subject to unlimited loss when you have to buy back the borrowed stock.
3. Shorting a stock is not allowed in all accounts, most notably IRA accounts.

A Put option gives the buyer of the option the right to sell the underlying stock at the Strike Price until the Expiration Date. The buyer of a put is bearish on the stock. Suppose you think Microsoft will have an adjustment problem in the first 6 months after Bill Gates retired. On July 18, 2008, Microsoft closed at 25.86 and you could have sold 100 shares short for $2586 which would be credited to your account. In January 2009 the stock decreased by 33% and cost 17.10 and you would have a gain of 8.46 points. However the interest you pay on the borrowed stock results in an average cost of 7% or $90 for a net gain of $756 or 30%.

Now take a look at what you could do with a Put option. You could buy a Put option with a Strike of 27.50 that will eon January 16, 2009 for a Premium of 3.20. With Microsoft at 17.10 the option profit would be the Strike Price, less the Stock Price, less the Premium paid: 27.5-17.10-3.20 = 7.20. This is a profit $720 on an investment of $320 or 225%.

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