Buying Naked Puts
Diversifying Your Portfolio
No matter how bullish the stock market may look at a particular time,you should always diversify your portfolio with a few uncovered (or"naked") put purchases. This week, we offer advice on how to pick theputs that are right for you.
Varying Bearish Positions
When you buy a put, you pay a premium for the right, but not theobligation, to sell the stock at the strike price anytime until theexpiration date. By itself, a long put constitutes a bearish position,one that is designed to make money if the stock declines.
If the stock rises, the most the investor can lose is the premium paid.This is because you do not have to sell the stock at the strike if thestock is above the strike. (You may also combine puts with theunderlying stock to create what is called a "married put" position.)
As with calls, puts can be in-the-money, at-the-money, or out-of-the-money.
An in-the-money put is one in which the strike price is above the stockprice. This put has what we call intrinsic value since the put holdercan buy the stock at the lower market price and sell it at the higherstrike price.
The remaining component of the put premium is its time premium. Thinkof this time premium as deductible insurance against making the wrongdecision. The more the put is in-the-money, the more you can lose ifthe stock goes the wrong way (i.e. up) and the lower will be your timepremium insurance.
Click Here For The Full-Sized Chart
In Graph 1,we show an example of an in-the-money put, the Marvel EntertainmentSeptember $22.50 put with the stock at $20 and the premium at $3.05.With 158 days to go to expiration, the option consists of intrinsicvalue of $2.50 and time premium of $0.55.
The most you can lose on oneput option (on 100 shares) is $305. This happens if the stock ends upabove $22.50. If the stock stays at its current price of $20, theoption will still be worth its $2.50 intrinsic value at expiration. Inthis instance, the most the investor will have lost is the original$0.55 time premium (or $55 on a 100-share contract).
If you are very bearish on the stock, but you want to limit your lossesshould the stock rise rather than fall, you should buy an in-the-moneyput.
Posted by: Value Line
...continued in "Part Two"
View Lawrence D. Cavanagh's post archive >