of the Put Option Contract
In all of the following examples, for the sake of better understanding, I will try as much as possible to use one figure for the price of the stock and one figure for the cost of the option. Understand, please, that these prices change in actual practice. The cost of an option on a stock selling at 50 would be less than one selling at 80 and, likewise, the cost of an option for 90 days would be less than one for 6 months on the same stock. The price of an option usually depends on the price of the stock, the duration of the option, the volatility of the stock, and supply and demand for the options in question.
a Put Option for Speculation
A man who thought that a stock selling in
the market at 50 would decline to possibly 30 could buy a Put option.
In buying an option, he should have some idea to what extent the
stock might move. In inquiring what a Put option would cost, he
might receive a nominal quote of, say, $350 for a Put at the market
for 90 days. Most options are negotiated "at the market," which
means at "the current market," when the option can be obtained by
the option-dealer. Suppose that the stock is selling at 50 and the
quoted price of $350 is satisfactory to you. You enter your order:
"Buy a 90-day Put on 100 XYZ [the name of the stock] for $350."
If you are trading through your stock-exchange broker, he will give
your order to an option-dealer who will contact one of his clients
who sells options on that stock and will attempt to buy the option
When, after this contact or several others, he has obtained the
Put option for you, he reports to the stock-exchange broker who
gave him the order, and he in turn reports to the customer: "Bought
Put 100 XYZ at 50 expires December 30 for $350." Let us say that
the man who bought the Put option, expecting a decline in the stock,
was wrong, and that the stock, instead of going to 30 (as he expected),
advanced to 70 and was selling there when his option expired. He
would have lost the $350 that he paid for his Put option. Bear in
mind that the limit of the man's loss was the cost of his Put option,
or $350, no matter how high the stock rose and no matter how wrong
he was, and that he would draw on the equity in his account to that
extent only. Suppose, on the other hand, he had sold the stock short
in the market. His loss would have been 20 points and still no knowledge
as to the possible extent of loss until he covered the short sale.
But in the purchase of the Put option his account would read:
Bought Put on XYZ at 50 for 90 days: Loss $350
Remember, too, that no trade has been made in the stock, so no stock-exchange
commission has been paid. A regular stock-exchange commission is
charged by your broker only if a transfer of stock is made in connection
with the option.
On the other hand, suppose the man's judgment was correct and the
stock declined to 30. If he had instructed his stockbroker to buy
100 shares at 30 and exercise his Put option, his account would
look like this:
||Sold 100 shares at 50 (through exercise of Put)
||Bought 100 shares in market at 30
||Bought Put at 50
||Profit on trade
The profit then would be almost 500 per cent of the cost of the Put contract. The profit is the difference between the cost of the stock plus the cost of the Put option and the proceeds of the Put that was exercised.
In all of these examples showing the use of options, the commission cost has been ignored. But at no time could the loss have been more than the cost of the option $350and any stock-exchange commissions would have been paid out of profit or out of possible recovery of part of the premium which was paid.
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