Basic Strategies for Options - Selling Puts

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Basic Strategies for Options - Selling Puts

Selling a put obligates the writer to buy the shares of the underlying common stock at specified price for a fixed period of time. The writer is paid a premium when the put is written in exchange for assuming this obligation.

Covered Put Writing

In certain circumstances an investor may find himself with a short position that has stalled. The investor believes the decline will continue eventually so he is unwilling to collapse the short position but he sufficiently uncomfortable to want to hedge his position while he waits for the next leg of the decline. Covered put writing is a viable solution.

A put writer is considered to be covered if he has a short stock position for the underlying security for which put options have been written. A covered put writer's potential profit is limited to the premium received plus the difference, if any, between the strike price of the written put and the original share price of the short position. The potential loss for this strategy is limited only by the premium received; losses for the short stock position are not protected. Consider this example.

George has already established a short position of 100 shares for International Business Machines (IBM) at $110. George thinks the stock will move substantially lower and for a while he is correct, the stock drifts to $100. After a week of slow trade near that level George gets anxious, he still thinks IBM will continue to move lower but he is worried about a near term "dead cat" or technical bounce. George decides to sell an IBM November 95 put for $2 per contract to collect some income while he waits for the bigger decline. His rationale is simple, if the stock does move below $95 he would be happy to close his position at that level for a profit and if IBM manages to hang around current levels or rally modestly he keeps the premium. Now let's run through the possibilities.

1.George is right on the money, IBM common stock does move modestly higher, rallying to $105 by the option expiration date in November. George earns a profit of $200 (proceeds from the sale of one IBM November 95 puts at $2 per contract) and his obligation to buy 100 shares of IBM common stock at $95 expires. He continues to hold his short position.

2. George is wrong and IBM common stock quickly declines to $90 per share. George is exercised and he is requested to buy 100 shares of IBM at $95 per share. This is not exactly how George had planned to close this trade but he still earns a profit of $1,700 (proceeds from short sale of IBM at $110 (11,000) plus proceeds from sale of IBM November 95 puts at $2 per contract ($200) less cost of buying IBM at $95 per share ($9,500)).

3. George is really wrong and IBM rallies to $120 per share. George's obligation to buy IBM common stock at $95 expires and he keeps the $2 premium ($200) but he losses big time on his short stock position. George decides he can no longer take the pain and he closes his short position in the stock realizing a loss of $800 (proceeds from short sale of IBM at $110 ($11,000) plus proceeds from the sale of the IBM November 95 puts at $2 per contract ($200) less the cost of covering the short sale of IBM at $120 per share ($12,000)).

The covered put strategy is appropriate for an investor with a short position that has become short term modestly bullish. The covered put writer gains some income while he waits for the next leg of the decline to begin, however potential losses for the covered put writer are limited by the premium received only. The covered put strategy does not hedge the short stock position.

Uncovered Put Writing

As you may have guessed, uncovered put writing involves the selling of put options when the investor does not have a short stock position in the underlying common stock. Like the uncovered call writer, potential profit is limited and risk can be substantial, in fact the only reason it is not unlimited is that a stock price can only decline as low as zero. In most cases when an investor sells a put option he is making the bet the stock price will rally or remain above the strike price of the written put option and he will keep the premium. His motivation is very simple; he wants to earn money from the writing transaction without the requirement to take a position in the underlying common stock.

We say most cases because there are certain instances when uncovered put writing can actually be a conservative strategy, allowing an investor to buy a stock below the current market price. Consider this example.

Dave likes to think of himself as a conservative investor. Procter and Gamble (PG) is his kind of stock, a big steady multinational firm with a long history of solid earnings increases. He wants to establish a long position of 100 shares but the stock; currently trading at $100 has been rallying to one new high after another. Dave would prefer to buy the stock on a pullback to the low $90's. Dave gets a bright idea, why not sell the right for someone to sell the stock to him at $95. He discovers that the PG November 95 puts are current trading for $3 per contract and promptly calls his broker to place an order to sell one contract. Now let's run through the possibilities.

1. Dave is right about Procter and Gamble, the stock falls to $95 and he gets assigned. His broker informs him that he is now obligated to buy 100 shares of PG at a price of $95 per share ($9,500). Dave gladly pays for the stock. Dave's uncovered put strategy allowed him to buy PG stock for an average price of $92 per share or $9,200 (cost of 100 shares of Procter and Gamble at $95 ($9,500) less proceeds from the sale of PG November 95 puts at $3 per contract ($300)).

2. Dave is wrong about Procter and Gamble stock and it continues to rise. By the option expiration date PG stock is trading at $110 per share. Dave earns a profit of $300 (proceeds from the sale of the PG November 95 puts at $3 per contract ($300)). If Dave's ambition had been to keep the premium he succeeded but unfortunately he still does not have position in Procter and Gamble common stock.

3. Dave is really wrong and Procter and Gamble stock promptly declines to $90 per share. Dave gets assigned and his broker informs him that he is now obligated to buy 100 shares of PG at $95 per share for a cost of ($9,500). Dave now has an unrealized loss of $200 (current market value of 100 shares of PG at $90 per share ($9,000) less cost of 100 shares of PG stock purchased at $95 under terms of assignment ($9,500) plus proceeds from sale of PG November 95 puts at $3 per contract ($300)).

Strange as it may seem uncovered put writing can be a very good strategy for the long-term investor if it is his intention to buy the underlying common stock. If the stock price declines below the strike price of the put the writer will be obligated to buy the stock at the strike price. Of course, the cost of this purchase will be at least partially offset by the premium received for writing the option. Losses will begin to accrue if the stock price declines by an amount greater than the put premium received.

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