True, but when you are dealing with a high possibility of breaking even over 2 years it does become a factor. Maybe not on 4k like the original poster mentioned, but on let's say 100k or 500k, not earning the 4% to 5% a year does hurt. Most instruments earn a high enough return to outpace inflation. Like I said before, it's not THAT big of a deal. I just wanted to be correct in saying it was not risk free because technically it isn't. More semantics then anything else.
Yes there are flaws to your logic. Of course there is risk. You could lose $370 and the interest on it if the option expires worthless! The issue with your logic is basically this: You can't compare buying the PUT + a CD for $3830 to doing nothing at all with the money. You should compare it to the alternative in which you invest the entire amount in a CD for $4200. This alternative will give you about $4617 in Jan08. NOT $4200. So. Your analysis does a good job of explaining why buying the PUT+CD is better than doing nothing at all with the money (keeping your $4200 in cash). It does nothing to explain why buying the PUT+CD is better than just buying a CD for the entire amount. I hope that helps.
I think the point was not to compare PUT + CD to just CD but compare PUT + CD to outright shorting. Outside of inflation and taxes there is no principal risk, I think you are talking more about opportunity costs- i.e., what you money could earn eslewhere while earning nothing if the put expires worthless. I think that if anyone wants to do this regardless of the downsides then going long the index call and putting rest in treasuries or zero coupons as was mentioend is the better alternative for someone wanting to go long the market but afriad of losing any of the initial capital. Of course it is still too passive a position for most here since many would simply buy the calls and put the rest of the money in another position.
if the put is priced correctly (ie, fat tails, volatility smile, etc) then the price of the put is the expected payoff of the put at expiration in many scenarios. therefore, if the price of the put is indeed the expected payoff of the put, then if you do this over and over, you are not profiting from your options trades because in the end, the profit is equal to the cost. thus you are just incurring transaction costs. therefore, it is better to put all your money into the CD. of course, if the put is not priced perfectly, then there is opportunity to profit (ie. if the imp was too high/low, the expected payoff was modelled wrong, etc). therefore, i think we are confusing it because of the CD issue. just because the interest on the CD can pay for the premium of the put, it doesn't mean it is a good trade, because the premium of the put can be put in the cd to earn extra return. also, it is not riskless. there is the limited risk of losing the put premium, even though you earn it back through the CD. So this trade should just be looked upon as a pure option trade. is the put under of over priced according to your market view. when we see it as this, then it we can now see the risk involved - the premium
Let me present it in a different manner: You want to short the QQQQ. You have 2 choices: 1) short the QQQQ with absolutely zero risk to your principal. 2) short the QQQQ with 100% risk to your principal Which is a better choice? To clarify the thinking, we need to put a "wrapper" around the put+CD package. When we do this, all you see is choice #1 above.
If the market is down 20% in two years, then there would be profit in the puts. I am not saying this is a good trade, but disagree with your statement that you are not profiting from your put trades. If the underlying drops you make money. The CD alone v. the CD/put is only better if the put is worthless by expiration. Again I would not recommend this necessarily but it is another means to take a bearish positions v. outright shorting of the stock. If you expect the market to drop significantly then the PUT/CD is better than putting it all in a CD. I still think the CD is a bad choice for this combo due to the CD restrictions. Then again I would simply buy the put outright lol.
My only point in comparing it to the pure CD position was to show that there is indeed risk. But OF COURSE THERE IS RISK!!!!! You just bought a put. You bought the put for $3.70. You didn't buy it for free. The fact that you can get interest on the rest of your money (in the form of a CD) has nothing to do with it. NOTHING AT ALL. The put may or may not be well priced. I respect the fact that some of you think the put is too cheap at $3.70. The price of the put is obviously related to the interest rate. In fact, if CD rates were at 6%, $3.70 would be an awful price to pay for the same put. Just ask the market maker who sells you the put and will be collecting short rate interest on the money from the sale of the $42 stock.
i understand what you mean. what i was saying is that i am imagining a monte carlo simulation, starting from today, with 1000 runs. in 1 run, if the market is down 20% down in 2 years, of courtse the put will make money. however, what is the probability of the market going down 20% in 2 year in the 1000 simulations? what is the probability of the market being down in 2 years? if the put was properly priced, then the profit from buying the put would be the price that you buy it at - ie it is fairly priced because it reflects the probability that the put is not worthless.
This is an entertaining thread So this whole thing is about risk management. If you invest your money anywhere, there is always a risk. period. To think that this put+cd "strategy" is risk free is the exact same as saying you can buy a $3.70 put and put the rest of a $10,000 "investment" into a savings account so that the interest expected is equal to the purchasing price of the put. Or do you go as far as saying, it's the same as using the $370 from my next paycheck that is above my budget to purchase a put, either way the worst I can do is break even! lol why not compare this situation to shorting a (bearish) stock and buying a call to limit the risk...same principle, different levels of risk. My point is that when you compare two investments and their risks involved it is often referred to as.....diversification!!!! lol