Smart portfolio builder – Using puts to buy stcoks.
We will discuss how to use put options to purchase stocks, whether it is profitable to do so by comparing purchase of shares/stocks outright and using put writing.
Different ways to purchase stocks | shares
Let us assume XYZ Company is trading at 100 per share.
Lot Size: 100 shares (This is important)
Both investors are looking to buy a minimum of 1 lot.
Mr. A does the following:
- Calls broker or places an order online.
- BUY 1 lot shares of XYZ company at 100 per share.
That is the straight forward way to purchase stocks.
Mr. A' purchase price is: 100 per share
Mr. B takes a different approach:
- Googles:
Option chain XYZ
(Not all stocks/shares will have an option chain.
We are assuming the stock in question does have an option chain.) - In the option chain of XYZ sees the PUT option prices for the strike right under todays price.
Let us assume this to be: 95. And the bid price 1.5
PUT Option
Strike: 95
Bid-Price: 1.5
Mr. B SELLS this Put option.
Mr. B purchase price: not fixed yet.
Time to compare expiry day profit-loss for both the investors:
There are three possible scenarios and well discuss them all:
(Comparison Date: Expiry, usually end of the month, can differ by exchange)
| |
||
|---|---|---|
| Purchase Price | 100 per share | 95 per share |
| Number of Shares | 100 | 100 |
| Profit-loss | (80-100) x 100 = -2000 | (80-95) x 100 + 1.5 x 100 = -1350 |
| Profit Loss Explained | (Todays price – Purchase price) x number of shares | (Todays price – Purchase price) x number of shares + Option PL |
That is a big difference in profit-loss.
Let us see what happened here.
Mr. B said I will buy the shares of XYZ at 95 per share at the end of the month(expiry) if you give me 1.5 per share today.
Mr. C who has XYZ stock said I think the stock price might fall and I want to make sure if it falls I can still get 95 per share. So he said to Mr. B I will give you the 1.5 per share and you buy my stock at 95 if price goes down.
The last day the price was down to 80, so Mr. C said here is my stock give me 95 per share. Mr. B took the stock and gave Mr. C 95 per share. The 1.5 per share stays with Mr. B.
So Purchase price for Mr. B = 95 – 1.5 = 93.5 per share.
Mr. A on the other hand just kept his purchase price of 100 per share.
| |
||
|---|---|---|
| Purchase Price | 100 per share | None |
| Number of Shares | 100 | None |
| Profit-loss | (100-100) x 100 = Nil | (100-0) x 0 + 1.5 x 100 = +150 |
| Profit Loss Explained | (Todays price – Purchase price) x number of shares | (Todays price – Purchase price) x number of shares + Option PL |
Let us see what happened here.
Mr. B said I will buy the shares of XYZ at 95 per share at the end of the month(expiry) if you give me 1.5 per share today.
Mr. C who has XYZ stock said I think the stock price might fall and I want to make sure if it falls I can still get 95 per share.
So he said to Mr. B I will give you the 1.5 per share and you buy my stock at 95 if price goes down.
The last day the price was 100, so Mr. C said keep the 1.5 per share I can sell my stock in the market for a higher price.
The 1.5 per share stays with Mr. B.
So Mr. B profited the 1.5 per share.
Mr. A on the other hand just kept his purchase price of 100 per share. So no profit no loss. (Not counting the brokerage and other charges)
| |
||
|---|---|---|
| Purchase Price | 100 per share | None |
| Number of Shares | 100 | None |
| Profit-loss | (110-100) x 100 = +1,000 | (100-0) x 0 + 1.5 x 100 = +150 |
| Profit Loss Explained | (Todays price – Purchase price) x number of shares | (Todays price – Purchase price) x number of shares + Option PL |
Mr. A made profit, Mr. B made very less profit.
Let us see what happened here.
Mr. A purchased the right share at the right time. He has a very good unrealised profit.(Can anyone consistently purchase the right share at the right time. And also can they sell in profits?)
Mr. B didn’t get to buy the share but got a very low realised profit. He can(if he has enough capital) repeat the same transaction for the 105 PUT option.
Mr. B said I will buy the shares of XYZ at 95 per share at the end of the month(expiry) if you give me 1.5 per share today.
Mr. C who has XYZ stock said I think the stock price might fall and I want to make sure if it falls I can still get 95 per share.
So he said to Mr. B I will give you the 1.5 per share and you buy my stock at 95 if price goes down.
The last day the price was 110, so Mr. C said keep the 1.5 per share I can sell my stock in the market for a higher price.
The 1.5 per share stays with Mr. B.So Mr. B profited the 1.5 per share.
Conclusion:
By the end of it, in 2 out of 3 cases, it is more prudent to buy stocks by writing/selling Puts rather than buying outright.
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All information here is for educational/research purposes only.