Building a Stock Position by Writing Put Options
5-Second Option Strategies for the Beginner
Writing put options, also known as a sell to open put option order, is a special portfolio management technique used by some advanced and professional investors to take advantage of certain circumstances in the capital markets, potentially increase income, and perhaps, at times, decrease risk. Although it is not something I think beginners should attempt, it can be useful to understand the foundation of how it works. To that end, I want to describe the basics.
The best way to explain writing put options, or selling put options to open, is to walk you through a hypothetical example. By seeing how the moving parts come together, it should make better sense.
Writing Put Options, Get Paid, and Buy a Stock You Want
Imagine that you want to buy shares of a fictional company, Acme Pharmaceuticals. After reading the annual report and analyzing the financial statements, you arrive at a conclusion. You decide that in order to earn your required rate of return, you can pay no more than $25 per share; a particular price which you feel is fair relative to the owner earnings. Today, the stock trades at $30 per share.
If you were like most investors, you might wait around and hope that the stock fell to your desired price. This can make a lot of sense, especially in ordinary interest rate environments when money market fund balances, which are usually how cash deposits in brokerage accounts or global custody accounts are kept if you have a large enough relationship size with your brokerage firm, are yielding 5% or more like they were not terribly long ago. In those sorts of circumstances, you are being paid to be patient.
There may be another alternative if the stars align correctly, you know what you are seeking, and there is fear in the market. Instead of sitting around and waiting for shares to fall to your desired price, you could write put options for the shares at $25. In essence, you would sell a promise to another party -- it could be a bank, mutual fund, corporation, or individual investor -- that if the shares of Acme fall below the threshold during the life of the option, the purchaser will have the right to require you to purchase those shares at $25.
You won't have a choice should they choose to exercise this right. You will have to come up with the $25 per share.
Why would you agree to do this? In exchange for your promise, the buyer of your put option will pay you a premium; think of it as an insurance premium, if you'd like. The amount of this premium depends on a number of factors but for our purposes, assume you are paid $1.12 per share to take on this risk. If you wrote ten put contracts (in case you aren't familiar with stock options, each option control covers a single round lot of 100 shares), you would receive $1,120 (10 puts x 100 shares = 1,000 shares x $1.12 premium = $1,120).
You'd also pay a modest commission, the specific rate depending upon the brokerage firm you employ.
You now find yourself in the enviable position of three potential outcomes:
- If the put option expires worthless and is never exercised, you keep the $1,120 premium income and are off the hook. You can take the money and close your account. You can reinvest the money in some other investment. You can write more put contracts. It's whatever you want.
- If the stock price declines temporarily and is exercised, you not only get ownership in the company you wanted but, before accounting for commission costs, you pay $25.00 - $1.12 per share, or $23.88 per share, not the $30.00 at which the stock traded when you originally eyed it. That is a 20.4% discount in price, which means you get more owner earnings and accompanying cash dividends for the same outlay.
- If the company behind the stock goes bankrupt, taking the stock to wipe-out, you still keep the $1,120 in cash plus you get the tax write-off of the loss, which can be considerable depending upon the circumstances, mitigating the total pain. (Attempt to avoid this outcome at all costs, of course. Still, there is a silver lining in that truly going bust from a position in a well-diversified portfolio is difficult to do.)
There are two other particularly relevant considerations in this scenario.
- If you want to avoid using margin -- and I suggest you do as I'm a fan of using cash accounts over margin accounts in part due to rehypothecation and hyper-rehypothecation risk -- you need to keep at least $25,000 in cash in the account during the duration of the contract in case the put option is exercised. If that happens, you'll see an assignment order for 1,000 shares at $25 each hit your account and the stock will be deposited when the cash is withdrawn. In actuality, you only need $25,000-$1,120, or $23,880 of your own money since you will generate cash when you write the put option.
- You get to earn interest income on the cash from the premium. Again, that isn't a lot at the moment in the low-interest rate environment in which we've found ourselves for the past few years but when interest rates are back to normal, that definitely plays into the calculation, sometimes in a meaningful way.
Learn More About Writing Puts
If you want to read more in-depth on this topic, check out Invest in Stocks by Trading Sell to Open Put Options.