A man is
short of 100 shares of XYZ which he sold short at 55 (he hopes to
buy it back at 30)—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 $350.00. 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.
Buying Stock to Make
a Long-Term Gain and Protecting the Commitment
An exception to the rule
that the acquisition of a Put is a short sale occurs when (1) the
stock and Put are acquired on the same date, and (2) 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 6 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
6 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 6 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?
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