In Highly Risky Markets, Consider Buying Options

I wrote about the advantages of buying puts over short selling a stock previously. Many investors (gamblers in this context) are worried about what's going to happen with Lehman Brothers (LEH). Those who bought the stock last Thursday and Friday were hoping some sort of deal would send the stock flying on Monday morning. Those who sold the stock short in the last couple of days are hoping for the opposite. Many in both groups probably didn't sleep well this past weekend.

I bought a few Lehman September 2.5 puts on Friday (along with Merrill (MER) January puts). While I'm certainly excited about all the news surrounding Lehman, it will be no great loss to me if the stock were to go up on Monday. Those who have shorted the stock, on the other hand, may be in for some pain if the stock goes up. Since there was no deal favorable to shareholders inked, those who have purchased the stock will get hurt, although unlike the shorts they can only lose as  much as they decided to gamble.

Both groups, however, would probably have been better off buying options instead. They could have risked less money to obtain the same desired profit. Consider the shorts. The September 2.5 put could have been bought around $0.40 per contract. (I bought mine for $0.51). That's $40 (plus broker commissions). Say the shorts are correct, and Lehman goes down to near $0 a share. That put will be worth near $2.50 a contract. Let's say Lehman drops and the 2.5 put trades around $2.20. For every $40 put at risk, they'd get a gain of $180.

The stock was under $4 a share when the put discussed above traded around $0.40, but let's say LEH traded at $4. Shorting 100 shares would place $400 in the short seller's account. If Lehman goes to $0, the short seller would get to keep the entire $400. The put seller would have to buy three puts (for a total of $120) to get a better potential gain ($540).

The put seller's risk, in this example, would thus be limited to $120 (plus commissions). The short seller's risk is unlimited. Suppose the Lehman news would have been good and the stock went up to $10 a share. The put seller in this situation will lose $120. The short seller will lose $600. The moral here: there's less risk and bigger potential gain to buying puts over short selling.

Now let's look at the long side. Suppose you bought 100 shares of Lehman at $4 a share. That's $400 at risk. Let's say you're right, and the stock goes to $10 on Monday morning. You'll have made a profit of $600. Let's say instead you bought the September 4 call, at the day's high price of $1.42 a contract. Again, let's say you're right about the stock's direction, and Lehman goes up to $10 a share. That call will be worth a little over $6. Let's say it's worth $6. You'll have made a profit of $458. Let's say you bought two contracts. You'd have put $284 at risk. Your return, however, would be $916.

Let's say you're wrong about the stock's move. No one wants to help Lehman, and its stock falls to near zero. Had you bought 100 shares at $4, you would lose $400. Had you bought two calls instead, you'd have lost $284.

When you're gambling with stocks, options offer greater potential rewards and less risks. And this is gambling, after all. No one knows what will happen when the markets open, not even those involved in the weekend deal making.

Disclosure: Author holds positions in LEH and MER