Investors employ selling or writing put options as a strategy to either buy reduced price stock or generate income. Here is a breakdown of what options trading is and what investors should consider when starting out with writing put options.
Buying stocks can be compared to casino gambling, where investors are betting against the house: if one player wins, everyone could win. Trading options is similar to betting on horses with each person betting against all the other people.
When an investor buys stock, they have a small portion of ownership in a company whereas, with options, investors have a right to buy or sell the stock at a predetermined price, by a specific date. Many traders think options are perplexing and very complicated, which is really not true.
There are two types of options: calls and puts. People buying a call option have the right, but, not the obligation, to buy a stock at the strike price at any point before the option expires. Someone buying a put has the right, but, not the obligation, to sell a fixed amount of an underlying asset at a predetermined price within a specific time frame.
When an option is sold, a security which did not previously exist is created. This is recognized as writing an option and defines one of the key sources of options since neither the associated company nor the options exchange issue options. When an investor writes a call, he or she may be obligated to sell shares at the strike price any time prior to the expiry date. When an investor writes a put, he or she may be forced to buy shares at the strike price anytime before the expiry date.
The strike price, also known as the exercise price, is the crucial determination of an option’s trading value.
Strike prices are determined when a contract is first written. Usually in increments of $2.50 and $5, the strike price informs the investor the price the underlying asset must reach before the option is valuable.
Trading options can move investors toward buying stocks in which they are genuinely interested.
Writing put options is a technique used by professional and advanced investors wishing to capitalize on certain conditions in the capital markets in order to possibly make money, and sometimes, lower risk. Understanding the basics of writing puts might be best accomplished through a hypothetical example:
An investor decides to invest in ABC Therapeutics. After analyzing financial statements and studying the company’s annual report, the investor decides he or she can pay no more than $20 per share in order to earn the required date of return. This price seems reasonable relative to owner earnings. The stock is trading at $25 today.
Many investors might stall their purchase in the hope of the stock falling to their desired price of $20. This strategy is logical, especially in normal interest rate climates when money market fund balances are yielding more than 5% (this was not always the case in recent years). In this instance, the investor is being paid to be patient.
Per the example, instead of waiting for the stock shares to dip to the desired price, the investor could write a put option for $20.
Essentially, the investor would sell a promise to another party, be it another individual investor, a corporation, bank or mutual fund. If the shares of ABC Therapeutics fall below the threshold during the option’s lifespan, the buyer will have the right to require the investor to purchase those shares at $20. If the purchaser chose to exercise this right, the investor would have no choice but to come up with the $20 a share.
Why enter into this seemingly risky proposition?
The buyer of the put option will pay the investor a premium, similar in concept to an insurance premium, if the investor chooses. The amount of the premium is dependent on a few factors, but, this example assumes the investor was paid $1 per share to assume the risk. If the investor wrote 10 put contracts (each option control covers a single round lot of 100 shares), he or she would receive $1,000 (10 puts multiplied by 100 shares equals 1,000 shares multiplied by the $1 premium). The brokerage firm employing the transaction would take a modest commission.
The investor in this scenario has three potential outcomes:
- Keeping the $1,200 premium income with no other obligation and the put option expires un-exercised: The investor can close the account and reinvest the money.
- Buying the stock at a discount because the price temporarily declined and the option was exercised: The investor paid $20 minus $1 premium per share, or $19 per share, not the $25 the stock was trading at when it was originally researched. He or she received more than a 20 percent discount in price which translates to higher owner earnings and cash dividends for the same money.
- Keeping the $1,000 in cash plus get a tax write-off of the loss if the company goes bankrupt, taking the stock to zero: Depending on circumstances, the write-off could be substantial. This is, of course, not the best outcome, but, neither is it a total loss.
Another consideration is the investor gets to earn interest on the cash from the premium.
Since investors are able to collect premiums, writing puts can be a sound strategy if a stock is rising or stagnant.
A seller is vulnerable to considerable risk if the stock price falls, even though the profit is limited.
Put writing is often employed in combination with other options contracts.