Chapter 11 - Puts And Calls

Most market investment and speculation is in actual securities bonds, preferred stocks, common stocks, and warrants. Further, most individual investments are made on an outright basis that is, they are bought and paid for, for cash. There is, however, a substantial amount of buying on borrowed money (like buying a house on a mortgage), either in "margin" accounts or by borrowing from banks or finance companies to purchase securities. A twist on the Shakespearean quotation that should guide you here: "Neither a borrower nor a lender be; but lodge thy surplus in good equity." However valid this garbled axiom may be, it is true that (1) most people nowadays buy outright for cash, and (2) they are, in general, better off that way.

All of which does not take away from the fact that more daring traders are always willing to borrow money, if they really believe in a situation; and they are constantly looking for devices that will multiply their gains by the creation of greater leverage. One of these devices is the "put" or "call" contract.

Description of Put and Call Options

These differ from what we have talked about so far in that they are not securities at all. They are merely legally valid and binding contracts or agreements. Although among the most sophisticated of trading vehicles, they are quite simple when properly explained. A "call" is a contract paid for in advance and purchased through a stock exchange firm that, for a specified sum, enables you to buy (usually) 100 shares of a certain stock at a specified price during a stated period of time. The price is customarily the actual market price of the stock on the day the contract is entered into; and the contract duration may be variously 60 days, 90 days, or six months.

The "put" is just the opposite. It permits you to sell 100 shares of a named stock at a stated price (again usually the current actual market price) at any time within 30 days, 60 days, or as long as six months.

The price you pay for either "option" will depend on (1) the volatility and activity of the stock in question, (2) the actual length of the contract, and (3) the current price of the stock. Obviously, a stock is likely to vary, or swing, more widely pricewise during six months than during a 30-day period; so the six-month contract will always cost substantially more than a shorter one.

Lest you get confused in theory, here are a series of actual "put" and "call" option contracts in familiar stocks, selected at random and available at reputable brokers on January 15, 1960.

                                    Price for        Price for        Price for        Price for
                                    a 90-day       a 6 months'    a 90-day       a 6 months'
                                    "call" at          "call" at          "put" at          "put" at
100 Shares of Stock     the market     the market     the market     the market
American Cyanamid     $ 525            $ 750            $ 450            $ 600
American Telephone     450               675               375               475
Chrysler                       600               875               450               750
General Motors            425               600               350               500
International Paper        800               1,200            700               1,000
New York Central        325               450               250               350
Standard of N. J.          325               500               275               400
U. S. Steel                    800               1,100            675               900
Western Union             700               1,000            600               850

From this brief shopping list you will perceive that, as of January 15, 1960, the brokers quoting these option prices generally expected the market to go up, since they uniformly charged more for the option to buy (the call) than for the option to sell (the put). So much for the technical description. But how do these options actually work? How can they make money for you? Or protect you against loss?

Examples of Uses of Puts and Calls

Let's take two examples. First, assume U. S. Steel common is selling at 80. You think it is going up a lot in the next six months. Acting on that belief, you can buy 100 shares of U. S. Steel at 80 and pay $8,000 (exclusive of commission and taxes). If Steel common within six months advances to 100, you can sell and realize 20 points, $2,000 profit on your $8,000 investment or a 25% gain.

Suppose that instead of buying the 100 shares however, you had bought a "call" for $1,100. When Steel common reached 91, you would have been "even"; and when it hit 100, you could have exercised your option to buy at 80 and then immediately sold at 100, realizing (gross) $2,000. This way, by staking only $1,100 instead of $8,000, you realized a $900 gain ($2,000-$l,100) or a profit on your money of about 80%. To dramatize the advantage further, $7,700 invested in seven "calls" (100 shares each) would have delivered a gross profit of $6,300 to you, instead of the $2,000 in the case of outright purchase involving an outlay of $8,000.
It is equally apparent that if, during the six month period in question, Steel common never advanced above 80, you would have lost the entire $1,100 you laid out for the call.

In the case of the "put," the situation would have been reversed. The put would have cost you $900 and, had Steel declined from 80 to 71, you'd have been even. At 61, you would have made $1,000.

So you see all this multiplies the potential for gain but greatly increases the risk. While it involves far less money than outright purchase, there is always the risk that you may lose your entire grubstake.

Puts and Calls for Defensive Purposes

Many people use puts and calls not for their potential for high leverage gain but purely for defensive purposes. Take again U. S. Steel at 80. Assume the holder of 100 shares is worried about some economic or political uncertainty which may cause his shares to sell off. Rather than make a total decision and sell his 100 shares forthwith at 80, he may buy a 90-day "put" for $675. If the stock sells off to 65, instead of being "out" $1,500 he will be "out" $l,500-$675, or $825, and have correspondingly cut his losses.

On the up side, a person can also insure his profits. Assume again the purchase of U. S. Steel at 80 and that it rises to 95. The owner needs the cash and sells, but still wants to keep an interest in the stock because he thinks it may continue to advance. So, having pocketed his $1,500 gain, he buys a call at 95 for 90 days at $800. If the stock advances further to 105, he still has his $1,500 plus $200 additional ($l,000-$800).

Equally, if traders think a stock will go down and sell it short (that is, they sell stock they don't own and borrow some to make delivery), a call for 90 or 180 days will provide some defense if the market goes up instead of down.

It is apparent that these puts and calls are nothing for beginners or amateurs. They are an important and useful tool for informed and seasoned traders. If their judgment (the traders') is right, a swift killing on relatively light capital outlay is possible. If the market goes against them, however, losses can be swift and permanent.

In conclusion, puts and calls are not securities but contracts. These contracts are usually made only in relation to securities enjoying active markets on a major exchange. The contracts are guaranteed by a brokerage firm. If you enter trading via this medium, you will benefit from dealing with specialists in this business.

Resume

1. Puts and calls are contracts, not securities.

2. They cover speculative trading over a relatively short period of time at most six months.

3. They make possible high-leveraged trading profits if your judgment and timing are correct; or you can swiftly lose all the money you place in them if the market goes against you.

4. There are brokers who specialize in these contracts whom you should consult; and there are some excellent articles and books on puts and calls in financial libraries or in certain brokerage houses should you wish complete knowledge of them.

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