Buying Naked Puts - Part Two
...continued from Part One.
At-The-Money Puts
An at-the-money put is one in which the strike price is equal to thestock price. As the stock goes down, the put immediately begins to pickup intrinsic value. Alternatively, if the stock rises, the put has noexposure other than the time premium paid.
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In Graph 2, we show an example of an at-the-money put, the September$20 put at $1.50, also on Marvel Entertainment. Since the strike priceis not greater than the stock price, this put option has no intrinsicvalue.
In this example, if the stock ends at the $20 strike or above,the investor loses the entire premium. If the stock declines below $20,the investor will reap the put’s intrinsic value at expiration, buthe/she will have lost the time premium.
At-the-money puts have higher time premiums than do in-the-money putsor out-of-the-money puts. This is because you are in a sense buyingcoverage in both directions with no deductible.
If the stock falls,your profits kick in right away. If the stock rises above its currentprice, the most you can lose is the $1.50 premium ($150 on a 100-sharecontract).
OUT-OF-THE-MONEY
An out-of-the-money put is one in which the strike price is below thestock price. Here you are buying insurance against missing out if thestock declines by a large amount. At the same time, your losses arequite low if the stock does not decline, or if it rises.
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In Graph 3, we show an example of buying the September $17.50 strikeput on Marvel Entertainment at $0.55. Notice that the stock has to bebelow $17.50 at expiration for you to reap a profit. On the other hand,if the stock does not move, the most you will have lost is $0.65 (or$65 on a 100-share contract).
You want to buy out-of-the-money puts to insure that you do not miss anespecially large decline in the stock. In a sense, you are buyingcheaper insurance on something that may never happen.
Posted By: Value Line
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About Lawrence D. Cavanagh
Lawrence D. Cavanagh is Editor (and Senior Analyst) of The Value Line Daily Options Survey. The Value Line Daily Options Survey offers evaluations and rankings on virtually the entire universe of regularly listed equity and ETF options, using the Value Line common stock ranks and proprietary volatility forecasting methodology. Before joining Value Line in 1991, Mr. Cavanagh was an options strategist for Capital Market Technologies (subsidiary of Elders Finance), helping design long-term synthetic foreign currency and gold option hedges. Before that, he was Director of Foreign Currency Options for the Chicago Board Options Exchange. Other work experience includes Dean Witter Reynolds (VP, Senior Currency Analyst), European American Bank (Director of Currency Forecasting) and the Federal Reserve Bank of New York (Assistant Economist).
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