The written put can provide the investor with extra income in flat to rising markets. It can also be used as a way to buy stock cheaply. This strategy is generally used when the investor expects the share price to remain steady or increase slightly over the life of the option.
|When to use|
|Market outlook||neutral to mildly bullish|
|The short put|
|Construction||short put X|
|Point of entry||market around X, but can vary|
|Breakeven at expiry||strike price less premium received|
|Maximum profit at expiry||premium received|
|Maximum loss at expiry||strike price less premium received|
|Margins to be paid?||yes|
|Synthetic equivalent||long stock, short call X|
Profits and losses
The maximum profit the investor can make is the premium received for writing the option, which will occur if the share price at expiry is above the strike price. The investor breaks even if at expiry the share price is equal to the strike price of the option less the premium paid. As the share price falls beyond this point, the potential losses of the sold put are limited only by a fall in the share price to zero. If the investor does not close out an in-the-money put before expiry, the option will be exercised and the investor will be required to buy the underlying stock at the strike price of the option.
- Cheap stock: many investors write put options as a way of buying stock cheaply. If the share price falls and the option is exercised, the purchase price is effectively the strike price of the option less the premium received - which is less then the price of the stock at the time of writing the option. If the share price at expiry is above the strike price, the option will expire worthless. The investor does not get to buy the stock, but has benefited from the receipt of the premium.
- Time decay: time decay works in favour of the put writer. If the stock price stays steady, the at-the-money option will deliver the most profit to the put writer, as this is the option with the most time value.
- Exercise: the put writer must be wary of early exercise. A put option is generally more likely than a call option to be exercised early.
If at expiry the stock is trading below the strike price, the put writer will be exercised unless the position has been closed out. As expiry approaches, the investor should consider buying back the put if they do not want to own the stock.
Alternatively, the investor could roll the option position to a later month and possibly a different strike price.
Points to remember
- This strategy can result in heavy losses if the share price falls significantly. Only write puts if you have the financial capacity to buy the underlying shares should you be exercised.
- Monitor the position closely. You will need to close out an in-the-money option in order to avoid exercise.
BIG Limited is trading at $5.00 at the start of March. You would be happy to buy the stock, but would ideally like to pay below the current price. You decide to sell an at-the-money put option. If the stock is below $5.00 at expiry, you will be exercised, and your effective purchase price for the stock will be $4.65 (the $5.00 strike price less the $0.35 received for writing the option). If the stock is above $5.00, the option will expire worthless, and you will have benefited from the option premium.
Sell 1 BIG May 500 Put @ $0.35.
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