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INVESTING


Put Options As A Hedge Against The Bear

07/19/00 02:08:57 PM
by David Penn

Many traders buy put options to hedge their positions against declining prices. Unlike short sellers, buyers of put options can limit losses more effectively, insofar as the put option buyer risks only the premium, the price of the option contract.

Security:   CPQ
Position:   N/A

A put option is the right, but not the obligation, to sell shares of a security up until a specified time called the expiration date, for a specified amount called the strike price. If the stock falls beneath the strike price, the trader can profit either by exercising the option or by simply selling the put option--which will have increased in value. If the stock climbs above the strike price, the trader could simply let the option contract expire. In this case, the price of the option might well be considered the price of "insurance" against the possibility of the stock price falling.

Below is a sample options quotation from the WALL STREET JOURNAL. In part, it reads:

 
Note that the fifth column in the table (Last) refers to the price of the option, or the premium. This number is multiplied by 100 to arrive at the dollar amount of the option.


Buying a CPQ July 30 put option gives the trader the right to sell 100 shares of CPQ at $30 per share. The premium on this option is $281.25. If CPQ falls to $25 per share and the premium on CPQ July 30 put options rises to 5 10/16, the trader can realize gains in two ways. One, the trader can buy 100 shares of CPQ at $25 per share and, at the same time, exercise the option contract to sell 100 shares of CPQ at $30. Two, the trader can sell the option itself, now worth 5 10/16. If CPQ's price rises above $30 per share, the trader might sell the option to discount the cost of the insurance.

Seeing how buying put options works in the options markets makes it clear how they can be part of an effective hedge. An investor holding a few hundred shares of CPQ could purchase a single CPQ July 30 put option contract. If the price of CPQ fell to $25 per share, the investor could exercise the contract, selling 100 shares at $30. Net gain on this transaction would be 2 1/8 ($5 per share profit on the trade, less the premium of 2 13/16).

True, if the price of CPQ rose above $30 per share, the investor who spent money on the put option would have less than the investor who took the downside risk. But buying put options as insurance is a matter of minimizing risk. And minimizing risk is what hedging--and active investment--is all about.



David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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