Hey guys, Just a quick question from a non-options trader. I'm reading a book in which the author describes how a number of firms directly exposed to a particular firm buys puts well below today's market price to hedge against the event of the firm going bankrupt. I can't figure out why they'd do this. If in fact the price of the underlying firm's stock drops sharply, wouldn't they be better off just buying puts at around the current market price of the stock? Wouldn't they have made more money that way, even at the higher premium? Am I missing something crucial concerning options theory?
Suppose DELL want's to hedge it's supplier Intel. If Intel goes down DELL may get into serious trouble (not a very good example). So DELL is going to buy insurance on the unlikely event that Intel goes down. The can buy OTM puts. Buying CDS would probably be a more cost efficient way to do it but anyways. They buy OTM because they will pay less for the insurance because OTM or DOTM puts will cost less in time value than ATM options. Example: INTC @ 18 initially January 2011 puts @ 17.50 = 2.60 January 2011 puts @ 10 = 0.48 Over five times less for the insurance and they still make over 50% of the down move.
Easy to show with a simple example. IBM is about 120. Let's say you've decided to spend $10,000 on long-term insurance (puts) against IBM's bankruptcy. If you buy the ATM jan 2011 120 puts - which are offered at 16.20, you'll be able to buy 6 of them. If IBM goes to zero, you'll make 120-16.20 = 103.80 on each put, which is $10,380 in dollar terms. So you make a total of $62,280 for the 6 puts you bought. If, on the other hand, you spent the $10,000 on the jan 2011 30 puts - which are offered at .20 - you could buy 500 of them. If IBM went to zero you would make 29.80 on each put, or $2,980. That's a total of $1,490,000 for the 500 puts. So if all you want to do is spend x dollars to insure against a company's bankruptcy, you get a lot more bang for your buck by going OTM. That example also helps explain why those 120 puts have an implied volatility of 21.35%, while the 30 puts have an IV of 50%. Think of it as the "lottery ticket" effect. $1,620 is a lot to risk for a shot in the dark. But anyone can afford $20.
DMO knows this, but for the sake of being careful when explaining things to beginners, this example is insurance against bankruptcy. If instead, you take a bearish stance in IBM, those puts are not the puts to buy. Bankruptcy is one thing, but betting on a decline you want to buy a put that has a realistic chance of becoming worth something. Mark