Puts and Calls, or “privileges,” have long been popular with a certain
trading element, either as a protection against loss in commitments
already made, or as a positive method of trading.
The theory and operation of privileges may be easily understood by
considering them in the light of insurance, the money paid for them as
a premium, and the funds received in case the privilege is exercised,
as a loss paid by the insurance company. It will be understood, that
in speaking of the _seller_ of puts or calls, the insurance company is
referred to, and that the _buyer_ represents the insured party.
The _buyer_ of a call has the right to _call_ for his shares or
commodity, at the price named in the contract at any time before its
maturity. The _seller_ of a call fixes a certain price at which he
agrees to _deliver_ stock, specifies the duration or time limit of the
contract, and receives from the buyer a certain sum or premium.
For example: United States Steel Common is selling at $40 per share;
A, the seller, offers a call on 100 shares at 43, good for ten days, at
a price of say, $100. B, the purchaser, pays the $100 and receives a
contract from A as specified above. Now suppose that at any time before
the expiration of the period named, Steel Common advances to 50. B can
call for the delivery of 100 shares of Steel at 43, and by selling it,
reaps a profit of $700, less the cost of the privilege, ($100), and
the brokerage. Used as a protective measure on short sales, the result
would be the same, as $700 would have been saved. That is to say, if A
is short of Steel at 40 and it advances to 50, his call has acted as
insurance against any loss over and above the $300 represented by the
rise from 40 to 43.
The “put” is exactly the reverse of the “call,” and is insurance
against a decline; or, in other words, an agreement to receive shares
at a specified price on or before a certain date.
Using the same illustration as before, let us assume that the price of
Steel Common is 40, and that A, the seller, offers a put at 37, good
for 10 days, at a price of $100. B, the buyer, is now insured against
any loss which may accrue through a decline below 37 in the ensuing
ten days. If he is long of the stock and it declines to 30, he may
deliver his shares to A at 37, or if he has purchased the “put” as a
speculation, he may buy 100 shares in the market at 30 and deliver to
B at 37, netting a profit of $700, less the price paid for “put” and
brokerage.
One of the favorite methods of trading in privileges is to buy or
sell against them when the price named is reached. For example, say B
holds a ten day “put” on Steel Common at 37, and the market for the
stock declines to 36 in five days. He may now buy 100 shares at 36 on
the theory that he has regained his original outlay of $100 and has
a possibility of profit through market action in the remaining five
days, while there is no possibility of loss. If the market advances
to, say 38, he may sell the one hundred shares purchased, and on
another decline to 37 or 36 may again purchase, repeating the operation
indefinitely during the life of his put. The “Call” is, of course, made
the basis of short sales on an exact reversal of this process. This
fashionable form of exercising privileges is facilitated by the fact
that “puts and calls” issued by members of the New York Stock Exchange,
are generally accepted by brokers as “margins”; B having paid A $100
for a “put,” as illustrated above, could, if Steel declined to 37 or
below that figure, buy 100 Steel and give his broker the privilege
issued by A, in lieu of a marginal deposit. The broker is satisfied,
as he gains a commission, and in the event of a further decline in the
price of Steel can call on A to receive the stock at 37 when the option
expires.
Another popular form of trading in privileges is to buy or sell half
the amount named in the privilege when it becomes “good” through market
action. If B holds a “put” on 100 Steel at 37, he may, at that price
or below, buy 50 shares. He is now in a position to profit by either
an advance or a decline. If the price advances to 40 he has three
points profit in the 50 shares purchased. If, on the other hand, the
market declines to 34, he still gains 3 points on 50 shares, for his
“put” protects him against a loss in the 50 shares purchased and he can
purchase another 50 shares at 34 and deliver to A at 37. In short, when
he makes his 50 share purchase at 37, he is both short and long of the
stock and must gain on a movement either way in the market price.
A “Straddle,” as the term is applied to privileges, is a combined “put
and call”. The purchaser gains on a movement in either direction. The
general rule is that the gain is to be represented by a market change
representing an excess of the amount paid for the “Straddle.” Thus if
A sells to B for $250, a straddle on 100 shares of Steel, when the
current market for the stock is 40, B is in a position to gain by
either an advance above 42½ or a decline below 37½.
The purchasers of privileges are sometimes perplexed by market changes
which are brought about by dividend payments. The rule is that the
dividend always goes with the stock. The simplest way to arrive at
correct figures is, to mentally lower the price of either the “put” or
“call,” by the exact amount of the dividend payment. Thus, if B holds
a “call” on Steel at 43 and a dividend of 2% is paid on the stock
during the life of his option, his “call” becomes operative at 41 as
the dividend goes to him. If he holds a “put” at 37, and 2% dividend is
paid on the stock, his “put” is not operative until 35 is reached, as
the dividend goes to the maker of the “put.”
Privileges in grain or other commodities are based on the same general
rules and principles as those on stocks. These privileges are heavily
dealt in on wheat and corn in Chicago. They are designated, however, as
“ups” and “downs” in order to evade local laws prohibiting transactions
in “puts and calls.” The “ups” are calls; the “downs” are puts. Most of
the grain privileges handled in Chicago, or based on Chicago prices,
are of a day to day character, insuring only for the next day’s price
changes. The ordinary charge is $1 per thousand bushels. For $1,
therefore, the small gambler, or speculator, may purchase, say a call
on 1,000 bushels of wheat at 90½ when the last price recorded was 90.
If wheat reaches 91½ during the next day’s session, he has a gain of
$10 less the cost of the “call” and brokerage.
The small capital required for this form of trading, the fact that
loss is limited to the original cost of the privilege, and the great
possibilities in case of extreme movements, make “puts and calls”
very popular. It may be said, however, that they are, as a rule, poor
property. The writer kept account of the transactions in “puts and
calls” handled through a large concern for almost two years and found
that only about 35% of the money paid for these privileges returned
to the purchasers. That is to say, the profit shown to purchasers of
“puts,” “calls,” and “straddles,” was only about $350 out of each
$1,000 received by the sellers. After deducting the item of commission
charges, it was found that the sellers of privileges reaped over
50% profit each year. The experiment referred to was based on grain
privileges, but would probably hold good in stocks. The _sellers_ of
these “puts and calls” are among the brightest men in the street, and
when they make prices they do so on the absolute basis that they have
the best of the bargain and the buyers are usually a public element.
In the test referred to, there were never three consecutive days when
either “puts” or “calls” were good. There was on one occasion in the
period consulted, an advance of over 20 cents a bushel in wheat in
three days, but “calls” were good only on the first day of the advance.
On this occasion the “calls” were good for about 2 cents per bushel on
the first day’s rise, but the sellers offered nothing for the second
day, except at prices far above the market, and although the market
advanced 6 cents per bushel, wheat was not “called.” On the third day,
prices for “calls” were prohibitive, ranging from ten to twenty cents
above the closing price and again wheat was not called, although the
market advanced 8½ cents.
In the accounts examined, one seller of privileges on wheat had an open
order to sell 100 puts and 100 calls every day at the ruling price. He
thus received $200 daily and invariably “took his loss” whenever the
privileges operated against him. That is to say, if wheat closed one
cent per bushel above the call price, he would be called for 100,000
bushels on his privileges, making him short that amount of wheat. This
he bought in at once and pocketed a loss of $1,000 less the $200
received. Although he accepted some severe losses now and then, his
account showed over $30,000 profit on a year’s business.
Another account was operated on a different principle by the seller of
privileges and resulted in even larger profits. This individual would
sell ten “puts” and ten “calls” on wheat each day. In the event of his
being called, i.e., short of the wheat, he would, on the next day sell
no “calls,” but 20 “puts.” In the event of a decline below the “put”
price, he had enough short wheat to protect ten of his “puts” and in
reality automatically close out his ten thousand short, frequently at
a profit. As has been stated, his profits were greater than in the
first instance quoted. There was, of course, a more highly speculative
element in his form of operating than in the other method, but the
operator was never either long or short more than 10,000 bushels,
and received about $6,000 a year or 60 cents per bushel from his
privileges, in addition to the accruing of profit or the curtailing of
loss by his mechanical method.
In the accounts examined the persistent purchasers of privileges all
finally lost money, except in a few cases where lines acquired on
“puts or calls” were carried to a successful conclusion in the course
of time. That is, a purchaser of “calls,” finding a profit in his
privilege, would call the wheat and _keep_ it. This, however, resolved
the matter into pure speculation, as the maximum benefits derived from
this form of trading can only be correctly measured by the profit shown
at the expiration of the “put” or “call.” That is to say, the seller
need suffer no greater loss than that shown when the contract he has
given matures, and consequently the profit to the buyer cannot be
greater except through speculation.
It would appear from these facts, that the purchasing of privileges
is a poor business proposition, while the selling of privileges is a
money making affair. This is true. We need only compare the kind of men
who _buy_ “puts and calls” and those who sell them to have this truth
made apparent. The late Russell Sage was a persistent writer of these
instruments and made a great deal of money by the process. The late
Edward Partridge also made a good deal of money in this manner in the
Chicago Wheat Market. He also used privileges to aid his manipulative
campaigns. On several occasions, he sold “calls” heavily through the
day, then suddenly bid wheat up just at the close of the market,
effecting a closing just above the call price. The scattered purchasers
would call the wheat and put Mr. Partridge short several millions at
a high price, which was just what he wanted. He could not have sold
as much wheat in the open market without breaking the price several
cents. On the same principle, he used sometimes to sell a great many
“puts” when he wished to cover a line of short wheat and rush the
price downward at the close, thus enabling him to purchase a great
line without disturbing the market by bidding for it. The process only
worked a few times, however. As soon as it was discovered it failed, as
the call price, when reached, met with such a wave of selling that it
was impossible to break through it, and the manipulator was “hoist with
his own petard.”
There is another drawback to the habit of buying privileges--a mental
one. They are frequently made the basis of positive trading with
disastrous results. The man who believes in an advance in certain
shares or commodities, frequently purchases privileges instead of
following out his own convictions by actual trading. Thus the man
who had good reasons for expecting an advance in wheat at the time
of the 20 cent advance mentioned above, and who used either “puts”
or “calls” or both, as a means of operating on his opinions, would
have reaped less than two cents a bushel during an advance of twenty
cents. He might, of course, have called the wheat on the first day
of the advance and remained long, but in that case he would merely
have been speculating with equal chance of loss or profit in ensuing
transactions. Aside from the initial two cent gain, he would have been
in no different position than if he had purchased and held the cereal
on margin.
It is the writer’s opinion, founded on the experience set forth above,
that it is much better to effect transactions in the ordinary manner,
than to depend on privileges. If “puts and calls” are dealt in at all,
they should be sold, not purchased. The insurance companies make more
money than is paid out in losses; so do the sellers of privileges. It
may be well to add, however, that the man who runs an insurance company
is in danger if he does not understand his business and his risks,
or if he enters the field without sufficient capital to provide for
possible initial losses. All this applies to the seller of privileges.