Using a Put to Make a Long-Term Gain in a Declining Market

You can, however, very easily spoil your opportunity to make such a long-term gain by handling such a situation wrongly; then, instead of creating a long-term gain taxable at 25 percent, you might end up paying a tax of 60, 70, or 80 per cent according to your tax bracket. Suppose, instead of selling the Put contract for the difference between the Put price of 50 and the market price of 30, you bought the 100 shares of stock in the market at 30 and exercised your option at 50. Your profit would be the same as in the first operation, but your tax would be a short-term gain. The reason? Your tax is based not on the duration of the option but on the length of time you hold the stock in question, and in this case you would have held the stock and sold it through your Put option all in one day. This makes the difference between your paying a tax of 25 per cent or one of 60, 70, or 80 per cent, according to the tax bracket you are in.

How Option Orders Originate

Before going into the further explanation and applica­tion of options, it might be interesting to explain how orders for options originate and are executed. An interested

Explanation of Chart

U.S. STEEL

A look at the accompanying chart of U.S. Steel common shows that it broke from 72 in the second week of July, 1957, to 48¼ by the third week in December of the same year. From 48¼ it rose in almost a straight move to just under 100 in January, 1959.

In the examples that I use as illustration, people might say that I am using only favorable ones. I am using not only examples of options that were profitable to the buyer but also those where the buyer of the option was wrong and lost his premium money. Some of the examples are taken right from the records and are options that were actually sold at the time and at the price mentioned.

On July 23, 1957, when U.S. Steel was selling at 70½, 6-month-and-10-day Puts were sold at 70 ½ for $475 per 100-share Put. The Puts expired on February 3, 1958, and on that date the stock sold at 56. The Put contracts could have been closed out on that date with a profit of $1,450, less the cost of the option and commissions for buying and selling the stock. Of course, during the life of the option, the stock sold for as little as 48¼. Had the holder of the option seen fit to close out his option in mid-December, he could have bought stock at 49 and exercised his option before expiration, showing a profit of $2,150. Even if the man's judgment of the market had been wrong-but it wasn't-his loss would have been limited to the cost of the Put option.

If someone had been farsighted enough to buy Calls on U.S. Steel in mid-April, 1958, when steel was selling at 56, his profit could have been enormous. On April 16, 1958, Calls were sold at 57 5/8, expiring in 6 months and 10 days (October 27, 1958), for $450 per 100-share Call. On October 27 the stock sold at 87, and if the Call had been closed out on that date, the profit would have been $2,937.50, less the cost of the option and stock-exchange commis­sions for buying and selling the stock. The owner of such a Call does not necessarily have to sell the stock after he Calls it-he may see fit to Call it and carry the stock, looking for a higher price at which to sell it. Of course, in calling the stock and carrying it, he will be required to margin the stock properly with his stock-exchange house.

party-perhaps in Detroit-will ask his stockbroker to ascertain on what terms a Call option can be had on a certain stock for, let us say, 90 days. The stockbroker will find this out through his New York office, which in turn gets in touch with an option-dealer for the terms on which a Call option can be had on that particular issue. The option-dealer might quote the contract at a nominal price of $400. This quotation is sent back to the customer in Detroit, and if the quotation meets with his approval, an order will be given to the option-dealer to "buy Call on 100 XYZ at market for 90 days for $400." On receipt of such an order, the option-dealer will get in touch with his clients who might be interested in selling such a contract, and when he has been successful in negotiating the trade, he will report to the stock-exchange firm from whom he re­ceived the order: "Sold you Call 100 XYZ at 70 for 90 days for $400 expires October 24." The Call option contract is then delivered to the stock-exchange firm which gave the order and the latter will pay for the contract from the customer's account and hold the contract, subject to instructions by the customer before expiration as to whether or not the option should be exercised. (The cost of federal and state tax will be added to the cost of a Call option. There is no tax required on a Put option.)

If the customer wishes to have the option exercised and it happens to be a Call on XYZ at 70, his instructions to his stockbroker will read: "Exercise Call on 100 XYZ at 70 expiring October 24 and sell stock at market;" or if he wishes to exercise his Call contract and carry the stock in his account his instructions should read: "Exercise Call on 100 XYZ at 70 expiring [date] and carry stock in my account."

Of course, if he chooses to carry the stock, he will be obliged to margin it according to stock-exchange require­ments. If he exercises the Call and at the same time sells the stock, he will be required to deposit only 25 percent

margin or $1000, whichever is greater.

It might be of interest at this time to explain that the option-dealer does not operate on a commission basis, but his profit is made in the difference between what he pays for an option and what he receives for it. An option-dealer having an order to buy an option for $500 will probably bid $450 to the maker of the option which he is going to sell for $500, and therefore make about $50 on the trans­action. It may be possible sometimes to buy the option for a lesser amount, and in that case the option-dealer's profit will be larger. Conversely, the broker may not be able to buy the option for less than $475 in order to fill his order, and therefore his profit would be $25. So much for the various uses of the Put contract.

Uses of the Call Option Contract

A Call option is a contract, paid for when it is purchased, which gives the holder the right to buy, at his option, a specified number of shares of a stated stock at a fixed price, on or before a fixed date. The option money is the amount paid for the option contract. Should the option be exercised, it is not applied against the purchase price of the stock. If you pay $500 for a Call on XYZ at 70 and you exercise the Call, you pay 70 for the stock, less any divi­dends or rights that belong to the contract.

The Use of a Call Contract for Speculation

A man thinks that a stock, now selling in the market at 50, is going to have a substantial rise. He buys a Call option on 100 shares at 50, good for 90 days, for $350 plus tax. The federal and state tax departments demand that tax stamps be affixed to Call options (but not to Puts). This tax, paid for by the buyer of the option at the time he buys it, is the same amount that would be paid by a seller on a sale of the stock at the Call price. The maximum is $12 per 100 shares and is fixed according to the dollar value of the stock involved. When the trader buys the Call option at 50, good for 90 days, for $350, this amount is the most he can lose, no matter what happens to the stock. If the trader is correct in his judgment and the stock rises to, let us say, 70, before his Call contract expires, he buys the stock by exercising his Call and sells the stock in the market at 70. His profit is $2,000 less the cost of the Call contract, and his account shows:

Bought call 100 XYZ at 50 for................... $ 350

Bought 100 shares at 50 thru Call................ 5,000 $5,350

Sold 100 shares at 70 ................................... $7,000

Profit.............. $1,650

The transaction shows a profit of almost 500 per cent of the $350 at risk.

In making such a trade, when the stock is Called and sold on the same day, the holder of the Call contract will be required to deposit margin of 25 percent of the sale price-70-with his stock-exchange broker until the trade clears on the fourth business day following the trade.

Please remember that not only does the cost of the option constitute the total risk to the holder, but the choice of exercising the option also belongs to the holder of the contract and he will exercise his option only if it

is to his advantage to do so. The seller or maker of the contract has no choice-he must live up to the terms of the contract at the option of the holder of the contract.

Closing Out a Contract for Partial Recovery

The preceding example of a Call contract for specula­tion showed a handsome profit. Suppose that when a Call option at 50 was about to expire the stock was selling at 52. While the holder of the Call contract could not recover all of his premium of $350, he could, nevertheless, Call for his stock at 50 and sell it in the market at 52, so instead of losing the $350 premium, he would recover $200 of it.

His account would read:

Bought Call XYZ at 50-cost................................ $ 350

Bought 100 shares a/c Call ................................ 5,000

$5,350

Sold 100 shares in market 52............................... $5,200

Loss.................... $ 150

(For simplification Stock Exchange commissions have been omitted.)

Selling Stock and Buying a Call to Maintain a Position

A man is "long" 100 shares of XYZ now selling at 50. The stock is owned outright or is held on margin, but the man needs the money in his business. However, he does not like to lose his stock position. He might consider the fol­lowing: He sells his stock at 50, releasing his funds, and at the same time buys a Call option at 50 good for 90 days at a cost of $350.00. If the stock advances, he exercises his Call and thereby re-acquires his stock. He may then sell the stock that he acquired through the Call and take his

profit, or he may care to carry the stock at 50 which is now selling in the market at 60. If, on the other hand, the stock declines to 40, he lets the Call option expire and now he can, if it suits him, re-acquire at 40 the stock that he sold in the market at 50. Through the Call contract, he accomplished two things-he released the $5,000 that he had invested and also had control over the same number of shares for the duration of his option, and at the same price that he sold them.

The Use of a Call Contract for Trading Purposes

If one is an astute trader and the market offers the opportunities, Call options can be used quite profitably and at all times with a limited risk.

Suppose a trader bought a 90-day Call option at the current market price of 50, for which he paid $350, and that the contract was to expire on December 31. Let us also suppose that some time in October the stock rose to 55, at which point the trader sold short 100 shares. This short-sale-and it must be sold as "short" stock-must be mar­gined with his stock-exchange broker, but at this point the trade is risk less. The trader has a 5-point profit less the cost of the Call at any time that he cares to exercise his option. But he doesn't care to exercise his option because it has about 2 months to run and the fluctuations in the market price of the stock in that 2-month period may give him additional opportunities to trade. Let us say that after having made the short-sale at 55, the market declines in another week or so to 50, where Mr. Trader sees fit to buy in or cover his short-sale. His account now looks like this:

Sold 100 shares at 55.............................. $5,500

Bought 100 shares at 50............................................. $5,000

Cost of Call Option ...................................... 350

Total Cost .... $5,350

Profit ............. $ 150

But the Call runs until December 31, and the trade which was made does not nullify the option. In another week or so, because of some news, the stock rallies to 56, where Mr. Trader again sees fit to sell short. Again he has a riskless, profitable transaction, and in a week or so the stock again declines to 50, at which point the short-sale is covered. On this trade another profit of $600 is added to the $150 already made.

Sold 100 shares at 56 ....................................... $5,600

Bought 100 shares at 50 ......................................... 5,000

Profit................... $ 600

Past performances of many stocks show that such oppor­tunities are far from rare and there have been instances of as many as twelve full trades made against a Call before its expiration. Without owning the Call, Mr. Trader might have been fearful of making a short-sale but, knowing that he could always cover the short-sale at 50 through the terms of his Call contract, he does not hesitate to trade. Suppose, for argument's sake, that after having made the short-sale at 56, the stock advances to 70 and stays at about that price. The trader merely exercises his call, thereby covering at 50, through the terms of his contract, the short-sale that he made at 56. Without the Call option he would have a 14-point loss, and even though the short-sale would prove to be a bad trade, his guaranteed trade would show a profit. Just as a Call can be used to protect a trade for trading purpose, Call options can also be used to:

Protect a Short-Sale at Time of Commitment

A man feels that a stock now selling at 50 will decline and sells 100 shares short in the market. Not willing to risk an unlimited loss if the stock advances, he buys a Call option at 50, good for 90 days, for which he pays $350. He is now guaranteed through the terms of his Call that he can buy 100 shares at 50 at his option before the con­tract expires, so if he is wrong, his loss will be limited to the cost of his Call option.

Now let's look at the operation both ways: Let's see what happens if the man is right and the stock declines and if he is wrong and the stock goes up instead of down. If the stock should go down to 30, as the man expects, he covers his stock in the market at 30 and takes his 20-point profit. Naturally, he won't want to exercise his Call option to buy stock at 50 because he can buy it better in the market, so he allows his Call option to lapse. He:

Sold 100 shares at 50 .......................... $5,000

Bought 100 shares at 30................................. $3,000

Bought Call at 50 .......................................... 350

$3,350
Profit.............. $1,650

One might say that he could have made the short-sale without having spent $350 for the protection. Certainly- but suppose that instead of the stock going down to 30, it had gone to 55, 60, 65, and then 70. What then? How far do you let your loss run? Well, some would say, why not sell the stock short and put a "stop loss" order in at 53½?

If the stock declined to 30, he would have saved the $350 and his profit would have been $2,000 instead of $1,650. That's fine, but suppose the stock rose to 54 first, stopped out the man's short-sale with a loss of $350 or $400, and then declined to 30. His original idea was correct-the stock did decline to 30-but the stop-loss order for protection was more costly than the Call option. If he had had the Call option, the rally to 54 would not have worried him because he would have been guaranteed through his con­tract that he could cover at 50, but the stop-loss order caused him a quick and definite loss.

The Use of a Call Option to Average

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