Fri Mar 30, 2007: Buying Big Blue Put Options (IBM)

IBM stock ran into overhead resistance at 100 and the trend has now turned lower, with the stock falling back below its 50-day moving average. As seen in the chart (click on the link below) the moving average has also rolled over and is heading down.

Chart of IBM stock

Investors who expect the downtrend to continue over the next couple months might want to consider buying put options. But which ones to buy?

We can compare some different choices by looking at the table below. May stock options expire on the third Friday of the month, May 18th.

If the goal is to double your money, then buying the May 95 put appears to be the best choice, as compared to the May 100 and May 90, because the price (89.30) at which the option would double by expiration day is highest for the May 95 put, which makes it most likely to be reached. Of course, these options need not be held until expiration day. You can sell them any day before that as well.

In case of a very large drop, the May 90 put would provide a superior percentage return. Yet notice that even for tripling your money the May 95 is still almost as likely to do so, because the triple price of 86.45 is not much lower than that of the May 90, 86.85.

The May 100 put is the "safest" of the three, in terms of having the highest break-even point.

Remember that when buying put options, you can lose 100% of your investment in a short period of time, if the stock price goes up above your strike price at expiration. So this risky strategy is suitable only for sophisticated investors who can afford to speculate with extra money that they don't need. Inexperienced investors can consider safer investments such as Certificates of Deposit (CD's) at banks that are insured not to lose principal and guaranteed to pay interest income. While current yields of approximately 5% per year are paltry compared to the theoretical returns from option speculating, such a percentage comparison can be misleading because it ignores two key factors. First, CD returns are guaranteed while option speculative profits are not. Second, through the magic of compound interest that 5% yield can grow exponentially over a large number of years. Most people should focus on excelling in their current job or career until they build up enough savings to be financially secure before they even consider risking losing money trading options. Furthermore, since option trading requires not just knowledge but an extra amount of time and effort, it's not worth it for most people to speculate on a small part-time basis. Once they have a large amount of speculative capital available it would make more sense because then, with the same amount of time and effort, they could possibly achieve profitable returns that are significant in size. Otherwise, their time is probably best spent focusing on their career. However, having said that, there is some important educational value in speculating with a small amount of real money instead of just "paper-trading."

Until next time, best of luck with your option investments!