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According to the terms of a put contract, a put writer is obligated to purchase an
equivalent number of underlying shares at the put's strike price if assigned an exercise
notice on the written contract. Many investors write puts because they are willing to
be assigned and acquire shares of the underlying stock in exchange for the premium received
from the put's sale. For this discussion, a put writer will be considered "covered" if
he has on deposit with his brokerage firm a cash amount (or other approved collateral) sufficient
to cover such a purchase.
MARKET OPINION: Neutral to slightly bullish.
There are two key motivations for employing this strategy: either as an attempt
to purchase underlying shares below current market price, or to collect and keep premium
from the sale of puts which expire out-of-the-money and with no value. An investor should
write a covered put only when he would be comfortable owning underlying shares, because
assignment is always possible at any time before the put expires. In addition, he should
be satisfied that the net cost for the shares will be at a satisfactory entry point if he
is assigned an exercise. The number of put contracts written should correspond to the number of
shares the investor is comfortable and financially capable of purchasing. While assignment may not be the objective
at times, it should not be a financial burden. This strategy can become speculative when more
puts are written than the equivalent number of shares desired to own.
The put writer collects and keeps the premium from the put's sale, no matter
how much the stock increases or decreases in price. If the writer is assigned, he is
then obligated to purchase an equivalent amount of underlying shares at the put's strike price. The
premium received from the put's sale will partially offset the purchase price for the stock,
and can result in a purchase of shares below the current market price. If the underlying stock price
declines significantly and the put writer is assigned, the purchase price for the shares can be above
current market price. In this case, the put writer will have an unrealized loss due to the high
stock purchase price, but will have upside profit potential if retaining the purchased shares.
Maximum Profit: Limited
Premium Received
Maximum Loss: Unlimited
Upside Profit at Expiration:
Premium Received from Put Sale
Net Stock Purchase Price if Assigned:
Strike Price - Premium Received from Put Sale
If the underlying stock increases in price and the put expires with no value,
the profit is limited to the premium received from the put's initial sale. On the other hand,
an outright purchase of underlying stock would offer the investor unlimited upside profit potential.
If the underlying stock declines below the strike price of the put, the investor might be assigned
an exercise notice and be obligated to purchase an equivalent number of shares. The net stock
purchase price would be the put's strike price less the premium received from the put's sale.
This price can be less than current market price for the stock when assignment is made.
The loss potential for this strategy is similar to owning an equivalent number
of underlying shares. Theoretically, the stock price can decline to zero.
If assignment results in the purchase of stock at a net price greater than the current market price, the investor would
incur a loss - unrealized as long as ownership of the shares is retained.
BEP: Strike Price - Premium Received from Sale of Put
Volatility Increases: Negative Effect
Volatility Decreases: Positive Effect
Any effect of volatility on the option's total premium is on the time value
portion.
Passage of Time: Positive Effect
With the passage of time, the time value portion of the option's
premium generally decreases - a positive effect for an investor
with a short option position.
If the investor's opinion about the underlying stock changes before the put
expires, the investor can buy the same contract in the marketplace to "close out" his position
at a realized loss. After this is done, no assignment is possible. The investor is relieved from
any obligation to purchase underlying stock.
If the short option has any value when it expires, the investor will most
likely be assigned an exercise notice and be obligated to purchase an equivalent number of shares.
If owning the underlying shares is not desired at this point, the investor can close
out the written put by buying a contract with the same terms in the marketplace. Such a purchase
would have to occur before the end of market hours on the option's last trading day,
and could result in a realized loss. On the other hand, the investor is obliged to take delivery
of the underlying shares at a possible unrealized loss.
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