How to Make Money from Share Market of Orissa and all over the World

Writing Put Contracts in stock Markets for making Money

A put option is a contract on an underlying stock. A put almost always represents 100 shares of the underlying stock. If there is any price movement in a put contract, it is usually in the opposite direction that the stock price is moving.

A little while ago, you were given an example of selling short. You sold a stock in the hopes of buying it back later at a lower price. You were using a tool of the bear: short selling. Another tool of the bear is buying a put. It is a way of profiting when a stock goes down in price without actually having to buy the stock. Why buy the put option instead of the stock because the put option may cost dollars per share, whereas the stock may cost tens of dollars per share. The put gives an investor the kind of leverage that comes from owning something that may double in price with just a change in price of two bits or more—or even an eighth of a dollar.

Now, the bull always does the opposite of a bear. He wants to sell puts because he does not expect the underlying stock to go down in price. The bear, however, expects the underlying stock to go down, so he buys the put.

But the writer of a put will not see his profits increase as the underlying stock moves in price. Writing puts is an income play for the bull, and the writer will never receive more than the premium (selling price) he gets when the put is written.

Let's look at the mathematics of profiting and losing by writing puts. These examples are very basic and not as detailed as they will be when we revisit puts in Part 3. They are meant only to give you a general idea of the how and why of puts.

Profiting by Writing a Put

You write one put contract for 100 shares of IBM stock. Assume the price of the shares at this time is 48.

You do not already own the put, but you can sell it just as you can sell a stock you do not already own.

The buyer of this contract you have just written now has the right to sell IBM stock at, say, $45 per share. You, in turn, will have received a premium (price at which you sold the put) of, say, $250. The put contract expires January 21.

The stock never drops below $45 per share before January 21. The contract, therefore, expires worthless. You make $250.

You have not sold the stock. Nor have you bought it. You have only written a contract that has given someone else the opportunity to profit if the stock declines in price, for as the stock declines in price, the put usually increases in price. ("Usually," because there are many factors that influence the price of a put.)

Writing a put contract is easy money in a bull market for the underlying stock. But there is a very serious downside to this game.

Losing by writing a Put

You write one put contract for 100 shares of IBM, giving the owner the right to sell the stock at $45 per share by January 21. The put is listed for $2.50. As each put represents 100 shares of stock, the true value of the put is $250, which is what you receive when you sell it. Assume that the price of IBM is $48 per share at the time you write the put.

The stock begins to fall in price, to $45, then to $40. Meanwhile, the price of the put has increased in value. It is now listed for $5. The owner of the contract now has the right to exercise her option. This means she can buy 100 shares of IBM stock at $40 and immediately sell them at $45 for a $500 profit. If she does, you will have to buy the stock at $45 so you can sell it to her. This means that while you made $250 on the put, you will have lost $500 on the stock transaction.

Your other option is to buy back your put before the owner exercises her option or the put generates any more losses. In this case, you are covering a short position that is showing a loss.

Writing puts is risky business. If IBM dropped to $30 per share, you might have to buy back that contract for $2,000. In this case, your loss would be $1,750 ($2,000 buy-back less the $250 sale price). At no time could you have made more than $250, but at any time you could have lost thousands... and more thousands.

Put writers generally try to limit "their risk by selecting underlying stocks that have little or no downside risk, or else writing puts with striking prices that seem to go well beyond probability. (A striking price is the contract price; it is the price at which the buyer of a put can exercise his rights.)

In the previous example, you could have played the game with less risk by writing a put on IBM that had a striking price of $40 or $35 instead of $45. But the further from the market price that the striking price is, the less money you will receive for writing the put contract. In fact, the premium for puts with lower striking prices may be so low that it is hardly advantageous for you to even consider them. In fact, you may want to bear in mind that the greater the premium on a put contract, the greater the risk.

But remember, you are not locked into your contract. You can always close out your position while it is still profitable, if it is ever profitable.

Early Profit-Taking on a Shorted Put

You have written a put on IBM stock, currently selling at $48 per share. The striking price is $45, and the expiration date is two months away. The premium you receive for writing the contract is $250.

Before the expiration date, the stock increases in price to $52 per share, and the put decreases in value to $.50 (or $50). You now learn that there is a good chance IBM will decline in price. Therefore, you call your broker and tell him to close out your position by purchasing the put back. Your order is executed, and you buy the put for $50. Your profit (excluding commissions, of course) is $200 ($250 premium for writing, less $50 for closing out the position).

In each of the above examples, you were dealing in one put. Because of their low price, speculators generally deal in many puts at one time. On the buy side, this is a worthwhile risk; but on the write side, it is too great a risk. The rule of thumb is this: when writing puts, write one or two at most, unless you are going to hedge your positions in some way.

It is important to remember, however, that it is not always possible to buy a put contract back at the same price or less than you sold it for. Such luck depends on the current market price of the stock, the striking price for the put option, and the time remaining until contract expiration.

Will a bull ever want to buy a put? Most assuredly; but he will be interested in using the put as a hedge.

Consider that a well-selected put usually goes up in price if the underlying stock goes down in price. Buying the put assures the bull that if his stock plummets, the put will reduce his losses and possibly even bring him into the black (profit zone). You may wonder how this can be, because the usual logic says that the losses on the stock and the gain on the put will just cancel each other out. This is not usually true. The way a put moves in price is very complicated. Many factors influence the rate at which it will increase or decrease. It may move on a 1-to-l ratio opposite the underlying stock; it may move on a 2- or 3-to-l ratio—or even better—opposite the underlying stock. A put gives the buyer a great deal of leverage because of its low price.

"Even so," you may argue, "the put will be a liability if the stock goes up in price; for as the stock goes up, the put goes down."

The trick answer to this question is that you can never lose more than you pay for a put (plus commissions). If you purchase $500 worth of puts to hedge on a long position, and if the underlying stock goes up $1,000 and the puts decrease to zero, you manage a $500 profit.

"Then," you will observe, "the stock must move high enough up in price to cover the cost of tile puts before I can profit."

Buying Calls

A call is just tile opposite of a put. But never for one moment believe that puts and calls always move in opposite directions. It is important to fix this fact in your mind as quickly as possible so you are extremely careful about buying puts and calls with the same expiration dates and striking prices on the same stock.

The put, as you have learned, is a contract giving the buyer the right to "sell" the underlying stock. The put contract specifies the striking price and the period of time during which the put can be traded or executed. Neither the buyer nor the writer of puts is ever dealing directly in the underlying stock but only in the put options on the stock. They may or may not own the underlying stock. Anyone may be both a writer and a buyer of puts.

The call, on the other hand, is a contract giving the buyer the right to "buy" the underlying stock. The call contract specifies the striking price and the period of time during which the call can be traded or executed. Neither the buyer nor the writer of calls is ever dealing directly in the underlying stock but only in the call options on the stock. Anyone may be both a writer and a buyer of calls.

One safety feature that puts and calls have in common is that, providing they have a value exceeding the cost of commissions, often you can bail out of your short positions by buying the options back, or bail out of your long positions by selling your contracts—just as you can do with stocks.

Bears write calls, but bulls buy them. Bulls buy them because well-selected calls will increase in price as the underlying stocks increase in price. Why buy the calls instead of the stock? Because the calls cost is less. Why buy the stock instead of the calls? Because the calls have time constraints, just like puts. And there are other contract limitations including the striking price and delivery requirements when a buyer exercises her rights.

Profiting by Buying and selling a Call

You have purchased one call on Merck stock for $300. The value of the stock when you purchased the call was $30. Before the expiration date of the contract, Merck advances to $35 per share. The call, meanwhile, has increased in value to $600. You decide to take your profits and sell the option. Your profit is $300 ($600-$300).

You never at any time owned the stock. But you profited as though you owned 100 shares. How much would 100 shares of Merck have cost? Why, $3,000. How much did the one call cost? $300. (Remember that each put or call is the equivalent of 100 shares of the underlying stock.)

It looks easy, doesn't it? But it isn't easy. There are a lot of things working against your chances of success. The stock can go down in price. The option will decay in price as the expiration date nears. The option may increase in price but then decrease below its original price before you sell. If something can go wrong, there is a good chance it will.

Losing on a Call Because of Time Decay

You have purchased one call on Merck stock for $300. The value of the stock when you purchased the call was $30. The stock remains in a very narrow trading range and does not increase the value of the call. It goes to $30%, back to $30, up to $30%. Meanwhile, the expiration date approaches, and the call begins to lose its value. It depreciates to $250, to $200, to $150. Finally, you decide to sell before the contract expires at $150, at which time the option becomes completely worthless. Your loss is $150 ($300-$150).

If the stock moved up enough to counter the time decay in the related option, you might have broken even or made a profit But when an underlying stock moves very negligibly in price, expect that the related option will decay, and decay rather rapidly during the two to three weeks before expiration.

Losing on a call Because of Expiration

You have purchased one call on Merck for $300. The value of the stock when you purchased the call was $30. Great things happen! The stock skyrockets to $40 per share and the call increases in value to $1,100. You lose track of the expiration date. Trading on the third Friday of the month ends. It is too late for you to sell your call. You lose $300, actually, and also lose the opportunity to have made $800.

The lesson is that you must pay attention to that expiration date. It means a lot to an option trader. Once a contract expires, it is worthless. The expiration date works for writers of puts and calk, but works against buyers.

Buying warrants

Warrants are also a type of stock option, as well as a fixed-income option. They are tradable instruments that confer on the buyer the right to purchase the underlying security or the right to sell the underlying security.

There are two types of stock warrants available to investors. These are subscription warrants and stock-purchase warrants. Warrants, just like puts and calls, have exercise (striking) prices and exercise dates (unless they are perpetual warrants). Unlike those assigned to put and call contracts, the exercise periods for stock warrants is usually long term.

The stock-purchase warrant confers to the owner the legal right to purchase shares of an underlying stock. stock-purchase warrants are often privileges attached not only to common stocks but also to preferred stocks, bonds, and debentures. But they do not necessarily have to be made available only to holders of certain corporate securities. They may also be issued separately for purchase by the public.

Subscription warrants are tied in with incentives for the purchase of newly issued stocks or bonds. They are rights to a stockholder to subscribe to a new issue in some proportion to their current ownership of the issuing corporation's common stock.

Just as with puts and calls, there are exercise prices and expiration dates to be taken into account when trading in these options. In any case, the great advantage to owners of stock warrants is their low price. As they move in relationship to the demand on the underlying stock/ a one-point movement in the stock may represent only a 10 percent gain for the stockholder but a 100 percent or more gain for the warrant holder.

The exercise price of a stock warrant is the price mat must be paid to take ownership of the underlying security. This exercise price will almost always exceed the current market price of the underlying security. For instance, if Karen Rigg, Inc. shares are selling for $20, the exercise price for the newly issued warrants will generally be above $20. If you should misjudge the potential of the underlying stock and purchase the warrants at a striking price that the stock will never reach, then you stand to lose everything you paid for the warrant. If you should judge the stock correctly and it advances passed the striking price, you can buy the stock at the striking price and then immediately sell it at the higher market price. Or you can just deal in the warrants, which will have increased in value as die stock climbed in price.

The warrant only gives you the right to purchase the underlying stock. You do not own the stock unless you exercise your option, just as in the case of call options.

stock Rights

stock rights are the privileges a corporation attaches to each share of common stock, allowing the owner of that stock to purchase full or fractional shares.

There are two major differences between stock rights and stock warrants. The first is that stock rights are usually offered free to current stockholders. The second is that stock rights usually carry an exercise price that is below the current market value of the related stock.

Rights work like this: Suppose that AT&T decides to issue an additional 10 mil¬lion shares of stock. It has the opportunity to offer them on the open market, to negotiate with investment bankers to buy the shares at or close to the market value of current stock, or to rise whatever capital is needed from existing shareholders. In this last case, the corporation offers rights to stockholders who wish to participate. These rights will usually allow a discount to participants on the purchase of addi¬tional shares, the number of which are specified by the rights. If the stock is selling at $60 per share, the rights may allow purchase of the shares at $55.

Greater detail on warrants, rights, puts, and calls will be forthcoming. But now that you understand the fundamentals, we can toss these terms around as we look at the concerns, issues, and opportunities for the independent investor like yourself. Then, as you begin to understand how these tools fit in with investment strategies, we can go deeper into the tool box.

Advantages and Disadvantages Bull Strategies

1. Buying stocks Long

Major Advantages: stocks can theoretically climb forever; you own a piece of the corporation, share in dividends. You can play for income and/or capital gains.

Major Disadvantages: stocks are generally slow climbers; need great patience, solid strategy, and great picks. You will tie up a lot of money.

2. Writing Puts

Major Advantages: You can greatly increase your investment income. Time decay works to your advantage.

Major Disadvantages: Picking the wrong underlying stock can result in tremendous losses. The initial amount received for selling the put is the maximum amount of money you can earn.

3. Buying Calls

Major Advantages: Return on investment can be substantial; you cannot lose more than your original investment. Big wins are possible.

Major Disadvantages: Time decay works against you; too many variables affect call movement; must keep an eye on expiration date, after which option becomes worthless.

4. Buying stock Warrants

Major Advantages: Low price in relation to underlying stock offers great leverage. Big wins are possible.

Major Disadvantages: Striking prices and expiration dates can work very forcefully against you.

5. Buying stock Rights

Major Advantages: Below market striking prices put you in the money quickly; low price affords great leverage.

Major Disadvantages: Incentives may bring you into additional stock during market downturns.

How to Make Money from Share Market of Orissa and all over the World