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Subject: Re: Getting Paid While You Wait Date: 5/31/2003 2:30 PM
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Hi Xfatox,

I read the thread. And made up examples generally are different from what you will find in a real money transaction.

I thought maybe we could go through an example using Netflix.

I will try to set up an example in my next post, but I won't be online till later tonight.

In the meantime, I did want to comment on a few of the paragraphs you mentioned.

When you sell a put, you are providing insurance for the buyer of the put. The insurance policy is for the buyer, yes, but it is from the seller. TMF Jeff obviously believes in this analogy because he wrote this in his May 15, 2003 article on stock options: In this case, you can buy a long-term put, which is basically like buying insurance for your shares.

I agree with that the insurance is for the buyer but is provided by the seller.


I don't understand what you're saying here. Like any stock, the price of the option (the premium) is set by the actions of the buyers and sellers in aggregate


No, this is not correct. The value of the option is set based on volatility of the underlying security. The only factor that changes with the demand is the spread between the bid and ask prices unlike stocks. The spread on options is very high compared to stocks.

For instance, if a stock remains 27 dollars throughout the day. And millions of people for whatever reasons started to trade the options on that stock. The option price would not change; the premium would not change except by the margin of the spread between the bid and ask price which would be narrow due to increased demand. And the more narrow the spread the better price option buyers and seller can get, but that is the only change in price that demand will create in an option price.

If the option price changed with demand, then in theory a strike price of 25 an option might sell for 15 dollars due to demand. If billions of people decided to buy that option; obviosly that cannot happen. The option price does not change because of increased demand for those options other than the spread between the bid and ask price.

I understand what you are saying about overvalution. But this is relative to the seller of the put. The company may be valued fairly and an investor still would like an extra margin of safety the sold puts would give him.

I am going to think as TMFJeff is probably thinking in that this is the way I think about it. He can later correct me if I read something into his thoughts that he was not meaning.


Since TMFJeff makes it clear he is interested in buying the stock at the lower stock price but does not want to pay more, he is by his actions saying that the stock he is interested in is near fair value according to his methods of valuing the stock. He may even be thinking it is undervalued but he requires a margin of safety the premiums on the puts would give. If it fails to go down, he gets the premium which will lower his future cost basis if he ever gets the chance to buy the stock. If next month the stock provides a similar opportunity he can repeat the process. Many stocks trade in a very large range throughout the year. Cheesecake Factory is one that has traded in a broad range allowing for options to be priced higher than normal due to increased volatility. And allow investors to sell puts over and over at the same strike prices.

I did not read anywhere where he indicated the stock was overvalued. You may have mentioned this, but I will have to check your other posts. I do not think Jeff was recommending doing this with wildly overpriced stocks.

I did this using wildly overpriced stocks in the bubble era and did quite well. A single JDSU put was bringing in over 800 a month. JDSU in hindsight was extremely overvalued. But next month it was even more overvalued.

Now is there an advantage using the sythetic puts. If one was using over 2 or three puts then there is a slight advantage and in theory it should begin leaning toward the synthetic put the more calls you sell.

On the other hand, I always use limit orders to reduce the spread. Most the time I can shave a dime off the price of the puts. I am certain I could do the same with the calls. However, interestingly enough, some brokers will not allow you to trade in nickel amounts. So though I could probably get the puts a dime higher to 1.30. I would not even be able to try 1.35 for the calls. I would have to settle for 1.30 or 1.40.

I would be unlikely to be able to get 1.40 and I would not be allowed to enter the 1.35. So the advantage is gone. So, I guess it is best to just sell the puts. But that is just my opinion.

Another problem is trying to use limit orders to sell calls while simultaneously buying the underlying security. You have to wait for one to execute before buying the stock. Or worse if you buy the stock you can fail to get the option above what you could have gotten if you just sold the put. In real life transactions it is not as easy to do synthetic puts and get the small advantage they might provide.

I am doing this in my head, since I have never worked with synthetic puts. So there may be a hidden advantage, but if so I cannot find it. Would you like to give an example using Netflix or I can do so tonight?



tom


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