leung, yes, that is what the broker generally wants to tell you, i.e. that you have to pay interest to borrow stock, and get interest from the cash raised, and that they cancel each other, and therefore you get nothing. I don’t believe this is true, since LTCM did it (“no hair-cut”), and I read that if you are a good client then you would have these better conditions (i.e. getting cash credited and not pay for borrowing stock). Also, quite frankly, who would get paid interest if your broker lends your MRK stock to some guy for short-selling? You don’t get anything, you only get the dividends, and when you sell your stock, you get the proceeds. So, on lending your MRK stock to a short-seller, the broker charges him the self-proclaimed “interest”. The broker doesn’t really deserve this interest, but it is a free-bee for him. I heard they are making good money from this.
Part two:
In-the-money puts have larger intrinsic values, i.e. the difference between strike price of the option and market price of the stock. They have nearly zero risk premiums since they are likely to end in-the-money as well. They do have, however, something I call “dividend premiums”, and (in the case of calls, mostly) “interest premiums”, since you are spared these extra expenses as opposed to shorting. Let’s take a random example: WM jan2008 $45 put. It currently trades at $5.80 and the stock is $41.90. Assuming these quotes are correct, I estimate that the option price (per share) is roughly composed of:
$3.10 intrinsic value,
$2.30 dividend (est. for the next 5 quarters)
$0.40 risk premium (for the risk of the stock rising above $45)
This seems like a better deal than shorting WM. When you short it, you have infinite risk, you have to pay the dividend, and you kind of have to pony up some cash to fund you margin account that you could otherwise use elsewhere.
With the option, your risk is only $5.80 (even if the stock goes up to $60), and that is all you have to send in to your broker. Assuming the stock doesn’t come your way and stays at $41.90 by Jan 2008, your option would be worth $3.10, and you lost $2.70 per share ($5.80-$3.10), so $270 for a contract of 100 shares. This $270 loss is a short-term capital loss subtracted from your short-term capital gains on Schedule D. Assuming you are net positive for the year you will save on some taxes. If you were short the stock, it would be more complicated to itemize your margin interest and your paid dividends.
