VI
Puts and Calls
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.