Owning the Market: Have Your Cake and Eat it Too
Let’s say a man is “short” 100 shares of XYZ stock which he sold short at 55 (he hopes to buy it back at 30), but the stock is now selling at 50. He originally deposited funds with his broker to margin this short sale, but he now has use for these funds.
How can he withdraw these funds from his account and still profit by a further decline of the stock? If he covers the stock that is short, he will no longer need margin for that short sale, and he can withdraw his funds. He then buys a put option at 50 (the market) for 90 days for $350. If before the expiration of the put option the stock declines to 30, he buys stock in the market at 30 and delivers it against his put contract at 50.
He has accomplished two things—he released the margin that he needed for his business or something else and through his put contract was able to share in the further decline in the market—all with the risk limited to the cost of the option. This operation brings to mind the oft quoted adage: You can’t have your cake and eat it—but in this case you can.
An exception to the rule that the acquisition of a put is a short sale occurs when the stock and put are acquired on the same date, and the stock is identified as that intended to be used in exercising the put. If these two requirements are met, the acquisition of the put will not be treated as a short sale and the special rule will not be applicable.
In order to get a long-term gain and have protection against loss for the entire holding period, you must buy a put good for more than six months and you must buy it the same day you buy the stock.
In other words, if the stock is selling at 50 and you buy 100 shares of stock at 50 and at the same time (that is, the same day) buy a put good for over six months, you are allowed to carry the stock fully protected by the put for the duration of the option (of course, the stock must be properly margined). If at the end of six months and a few days the stock has risen to, say, 75, you can sell out your stock, and your profit is long-term gain. In this case, the holding period of the stock is not affected by the purchase of the protective put option.
If, on the other hand, by the expiration of the put the stock has declined to 30, you exercise your put at 50, and your loss is limited to the cost of your put option plus stock-exchange commissions and taxes. In this case you have had an opportunity to make an unlimited long-term gain with a risk limited to the cost of your option and commissions. How else could you have an opportunity to make a possible unlimited profit with a small limited loss?
Put options are good for the conservative investor who isn’t looking to make huge gains, but more important, he doesn’t want to sustain big losses.
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