When Expecting A Severe Decline in Options, This Will Happen




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If, however, the contract has some time to run, he may want to hold the stock, which he bought, looking for a rally and a chance to sell his stock in the market and thereby leave himself open to repeat the operation, if possible.

Trading in Odd Lots Against a Put Option

In the aforementioned example of trading against an option, the trading was done by buying 100 shares of stock at 30 and selling the stock at 50 through the exercise of a Put option.

Another way of operating against such a Put option is to buy stock in odd lots of, say, 25 shares each on a scale-down as follows: the holder of a Put at 50 might buy 25 shares at 36, 25 shares at 34, 25 shares at 32, and 25 shares at 30. Of course, each purchase in the market must be margined according to stock-exchange regulations, but the man who has no definite opinion as to where the stock should be bought against his option "scales" his buying orders until he has bought 100 shares, and then he may, if he cares to, deliver these shares against his Put option contract.

His account would then read:

Bought 25 shares at 36 cost $ 900.00
Bought 25 shares at 34 cost

850.00

Bought 25 shares at 32 cost 800.00
Bought 25 shares at 30 cost 750.00

$3,300.00

Cost of Put 350.00

$3,650.00

Sold 100 at 50 through exercise of Put

$5,000.00

Profit

$1,350.00


If, however, the contract has some time to run, he may want to hold the stock, which he bought, looking for a rally and a chance to sell his stock in the market and thereby leave himself open to repeat the operation, if possible.

Trading Several Times Against an Option

Suppose that instead of expecting a severe decline, the trader expected that we would for the next few months have a market that would be a "trading market," one that would fluctuate mildly. The ability to use an option to trade against can be quite profitable to the holder, for many trades can be made against the same option, and each time a trade is made, that trade is fully protected against unlimited loss if the trader's judgment should be wrong. For example, let us say that a man buys a Put option on 100 shares at the current market price of 50 for 90 days for $350. In a few days the stock declines to 46, and the trader, feeling that the drop has been enough for the moment, buys 100 shares at 46 through this stockbroker. He must deposit the normal margin required for such a purchase as the option cannot be used for margin. In making such a purchase, he is guaranteed against loss because the holder of the Put option can, up until the expiration of the Put contract, deliver his stock at 50 at his option. Now he is holding 100 shares which cost 46, and since his Put option guarantees that he can sell it at 50, he is assured of no loss. Say that in the next week or so the market rallies and the stock rises to 51 and the trader decides to sell. To recapitulate: the trader bought stock at 46 and sold it at 51, yet he still retains his Put option, which does not expire for some 70 days. He has made a gross profit of five points and may have further opportunity of making additional trades—and each time he buys stock under the price of his Put during the life of his option contract, he is guaranteed against loss.

After having bought stock at 46 and sold it at 51, the same trader might, if the stock declines again, have another opportunity to buy more of it and, after another rally, have another chance to take a profit. The number of opportunities to make such trades is limited only by the fluctuation of the stock in the market and the trader's ability to judge the stock's movements. The reader should realize that it might be possible to make many such trades during the life of an option. Note that a trade or trades against an option do not nullify the option contract. The contract is operable until it expires or is exercised.



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