Writing put options strategy
Put options are most commonly used in the stock market to protect against the decline of the price of a stock below a specified price. In this way the buyer of the put will receive at least the strike price specified, even if the asset is currently worthless. If the strike is K , and at time t the value of the underlying is S t , then in an American option the buyer can exercise the put for a payout of K-S t any time until the option's maturity time T.
The put yields a positive return only if the security price falls below the strike when the option is exercised. A European option can only be exercised at time T rather than any time until T , and a Bermudan option can be exercised only on specific dates listed in the terms of the contract.
If the option is not exercised by maturity, it expires worthless. The buyer will not exercise the option at an allowable date if the price of the underlying is greater than K. The most obvious use of a put is as a type of insurance. In the protective put strategy, the investor buys enough puts to cover his holdings of the underlying so that if a drastic downward movement of the underlying's price occurs, he has the option to sell the holdings at the strike price.
Another use is for speculation: Puts may also be combined with other derivatives as part of more complex investment strategies, and in particular, may be useful for hedging. By put-call parity , a European put can be replaced by buying the appropriate call option and selling an appropriate forward contract.
The terms for exercising the option's right to sell it differ depending on option style. A European put option allows the holder to exercise the put option for a short period of time right before expiration, while an American put option allows exercise at any time before expiration. The put buyer either believes that the underlying asset's price will fall by the exercise date or hopes to protect a long position in it.
The advantage of buying a put over short selling the asset is that the option owner's risk of loss is limited to the premium paid for it, whereas the asset short seller's risk of loss is unlimited its price can rise greatly, in fact, in theory it can rise infinitely, and such a rise is the short seller's loss.
The put writer believes that the underlying security's price will rise, not fall. The writer sells the put to collect the premium. The put writer's total potential loss is limited to the put's strike price less the spot and premium already received. Puts can be used also to limit the writer's portfolio risk and may be part of an option spread. That is, the buyer wants the value of the put option to increase by a decline in the price of the underlying asset below the strike price.
The writer seller of a put is long on the underlying asset and short on the put option itself. That is, the seller wants the option to become worthless by an increase in the price of the underlying asset above the strike price.
Generally, a put option that is purchased is referred to as a long put and a put option that is sold is referred to as a short put. A naked put , also called an uncovered put , is a put option whose writer the seller does not have a position in the underlying stock or other instrument.
This strategy is best used by investors who want to accumulate a position in the underlying stock, but only if the price is low enough. If the buyer fails to exercise the options, then the writer keeps the option premium as a "gift" for playing the game. If the underlying stock's market price is below the option's strike price when expiration arrives, the option owner buyer can exercise the put option, forcing the writer to buy the underlying stock at the strike price. That allows the exerciser buyer to profit from the difference between the stock's market price and the option's strike price.
But if the stock's market price is above the option's strike price at the end of expiration day, the option expires worthless, and the owner's loss is limited to the premium fee paid for it the writer's profit.
The seller's potential loss on a naked put can be substantial. If the stock falls all the way to zero bankruptcy , his loss is equal to the strike price at which he must buy the stock to cover the option minus the premium received.
Because you can only make a fixed amount of profit, it's best used when you are expecting a security to go up in value by just a small amount. This is because the short put involves selling options contracts and you can therefore profit from the fact that time decay reduces the value of those contracts over time. This strategy offers you no real protection against the underlying security falling significantly in value, so you should only use it if you are confident that the security isn't likely to decrease in price.
This is a very straightforward trade. You simply place a sell to open order with your broker to write puts based on the underlying security you are expecting to increase in price. Generally speaking, you would write puts options that are close to the money and do not have a long time until expiration. There is less time for the price to fall, which would cost you money. If you wanted to increase your potential profits you could write more expensive in the money puts with a higher strike price, but you would then need the security to increase more in price for the contracts to expire out of the money.
You could write out of the money puts so that you could even profit if the price dropped slightly, but these would be cheaper, and you would make less profit. Whether you choose to write at the money, out of the money, or in the money contracts is entirely up to you and there's no particularly correct way to go. You effectively get your profits up front at the point of writing the puts. This transaction results in net credit, because you will receive money into your brokerage account for writing them.
This net credit is the maximum amount that you can profit. Basically, if the puts you write expire worthless, then you have no further liability and the payment you received is all profit. Of course, if at any point before expiration, the contracts are worth less than when you wrote them. Then you can use the buy to close order to buy them back.
If you do this, then your profit will be the difference between the original credit and the amount you spend to buy them back. As mentioned above, you can increase the potential profits put by writing in the money puts for a higher net credit, but you'll then need the price of the underlying security to increase further for these contracts to expire worthless.
The risk is that the underlying security falls in price, and the puts you wrote are assigned. If this happens, you are obliged to buy the underlying security at the agreed strike price regardless of what price the security is trading at.
This is why the short put is a risky strategy. If the security falls dramatically, then your losses could be quite substantial compared to the amount you received for writing the puts in the first place. If you choose to write out of the money puts, then you could still make a profit if the price of the underlying security only drops by a little bit.
However, out of the money options are obviously cheaper so you would make less from the upfront credit you receive. Because of the risks involved, we wouldN't recommend the short put for beginners and would advise that you only use this strategy if you are confident you know what you are doing.
There are definite advantages to using this strategy, but there are also a number of disadvantages too. One of the biggest advantages is the fact that you receive an upfront credit, but this is somewhat offset by the fact that the strategy will require margin, meaning that you will have to tie up capital in your brokerage account.
You will also usually need a high trading level, which will rule the strategy out for a lot of traders. It is, however, relatively simple and is often favored by traders due to the ease of use and the relatively low commission costs. Another advantage is that it offers the potential for profit if the price of the underlying security stays the same, which makes it a good choice if you aren't completely convinced the price will rise. The potential profits of the strategy are limited though, and if the underlying security increases a lot in price, then you won't get any extra returns.