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?
A Put Option vs. a "Stop-Loss" Order to Protect a Purchase
Mr. A. buys 100 shares of stock at 50 and protects the purchase by buying a 90-day Put at 50, for which he pays $350. In the first 20 days, the stock declines to 45. Mr. A. doesn't have to worry-his Put option guarantees that he can sell the stock at 50 at any time before the Put contract expires-so he waits. In the next 30 or 40 days (his Put option hasn't yet expired) the stock rises to 60, and at this price Mr. A. sells his stock. He has a profit of 10 points less $350-the cost of his Put option.
Mr. B., on the other hand, buys 100 shares at 50 and at the same time enters a "stop loss" order at 46. Such an order becomes an order to sell only if the stock sells at 46, and then it becomes an order to sell at the best price obtainable. If such an order is executed or "touched off," Mr. B. will probably get 46 or less for his stock-a loss of about $400 and he is out. His loss is greater than the cost of the Put option which Mr. A. bought, and he cannot benefit when the stock rises to 60. See the difference?
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