Spread Trading: An Introduction to Trading Options in Nine Simple Steps

CHAPTER 15

R&R for Lon

Lon was eager to find Cass and explain the new trade he had made with Shorty. “Look,” he said, “I’ve done this option contract a different way this time. Doing only long calls, I was never able to find a way to make money, or at least reduce risk, when stocks went down. Long calls were great for bullish stocks, but not for bearish ones. But I’ve found a way around that now.

“Here’s the deal we just made,” he continued. “I expect Nextall stock to go down. The shares are now at $40 but could go as low as $30 or even $25. I’ve paid Shorty $1.50 per share to have the right to sell my shares to him anytime in the next month at $35! So even if the stock goes down, I can still sell my 100 shares at this $35 strike price.”

It looks like the same principle as buying insurance on our home and cars. If something bad happens, we’re protected.

“It looks like the same principle as buying insurance on our home and cars,” observed Cass. “If something bad happens, we’re protected. We pay a premium, sure, but it’s worth it. Is this something like that?”

“Exactly. In this case, the debit I pay is like an insurance premium. Paying this debit to Shorty, I have the right to sell shares to him at a certain price even if the market price is lower. It’s financial protection. We call this a long put (don’t ask me why—there’s a reason, but don’t ask me), so I might even call this a protective put. It’s a put that protects my investment.”

COST BASIS

“What’s your cost basis for this ...