By writing puts on stocks you’d like to owe, you can lock in a purchase price for a set number of shares. But if the stock price increases, you may still profit from the premium you receive.
Investors who choose to write puts are often seeking additional income. If you have a neutral to bullish prediction for a certain stock or stock index, you can sell a put on that underlying instrument, and you’ll be paid a premium. If the underlying instrument doesn’t drop in price below the strike price, the option will most likely expire unexercised. The premium is your profit on the transaction. For example, say you think that the stock of Lincoln Mining (LMN), currently trading at $52, won’t drop below $50 in the next few months. You could write one LMN put with a strike price of $45, set to expire in six months, and sell it for $200. If the price of LMN rises, stays the same, or even drops to $46, your option remains out-of-the-money. You’ll keep the $200.
A more conservative use of put writing combines the options strategy with stock ownership. If you have a target price for a particular stock you’d like to own, you could write put options at an acceptable strike price. You’d receive the premium at the opening of the transaction, and if the option is exercised before expiration, you’ll have to buy the shares. The premium you received, however, will reduce your net price paid on those shares.
For example, if the price of LMN stock drops to $42, your short put with a strike of $45 is in-the-money. If you are assigned, you’ll have to purchase the stock for $4,500. That amount is partially offset by the $200 premium, so your total outlay is $4,300. You would pay a net price of $43 for each share of LMN stock. If its price rises in the future, you could realize significant gains. Or, you could close out your position prior to assignment by purchasing the same put. Since the option is now in-the-money, however, its premium may cost you more than you collected when you sold the put.
Due to the risks involved, and the complications of margin requirements, writing puts is an options strategy that may be most appropriate for experienced investors.
Writing options is generally considered riskier than holding options.
With any put writing transaction, your maximum profit is limited to the amount of premium you receive.
If you decide to close out your position before expiration, you might have to buy back your option at a higher price than what you received for selling it.
At exercise, the potential loss you face is substantial if the price of the underlying instrument falls below the strike price of the put.
If you write a put and it expires unexercised, your return may seem simple to calculate:
Subtract any fees and commissions from the
premium you received. But writing puts usually
requires a margin account with your broker, so you
should include in your calculations any investing
capital that was held in that account, since it could
perhaps have been profitably invested elsewhere
during the life of the option.
For example, if you write the LMN 45 put, you’d receive $200. But your broker would require
that premium, along with a percentage of the $4,500 needed to purchase the shares, to be held
on reserve in your margin account. The capital is still yours, but it is tied up until the put expires
or you close out your position.
If you write a put that is exercised, the premium you receive when you open the position reduces
the amount that you pay for the shares when you meet your obligation to buy. In the case of the
LMN 45 put, the $200 premium reduces what you pay for the stock from $4,500 to $4,300. If
you plan to hold the shares you purchase in your portfolio, then your cost basis is $43 per share
If you don’t want to hold those shares, you can sell them in the stock market. But if you sell
them for less than $43 per share, you’ll have a loss.
Source: The Options Industry Council otherwise known as OIC.