Last week, I discussed writing puts as an alternative way to accumulate stock. To re-cap, writing a put option means you are selling someone else the option of selling a stock to you at a certain price for a certain amount of time. They may choose to exercise this option when the stock in question is trading below the strike price of the put option contract. If this happens, the stock is “put to you” – meaning you are forced to buy it.
As an example, let’s assume that stock XYZ is trading at $50/share. If you sell a put option for $45/share then if the stock drops in value to $45/share, you may end up being forced to buy it. If XYZ never gets down to $45/share you may not end up being forced to buy it. No matter what though, you will get to pocket the sale price of the put option contract. If XYZ never makes it to $45/share by the time the option contract expires, your obligation to buy the shares also expires and in this case you just pocket the premium.
I mentioned that there were a few scenarios where writing a put might not be so great. The first is if the stock takes off in price (remember you were willing to accumulate it) without first getting to $45/share. In this case you are potentially foregoing participation in that upside. The second is if the stock drops dramatically. It could suddenly be trading for $35/share, and you would still be forced to buy it for $45/share.
One way to adjust for this latter risk, is to also buy a put option with a lower strike price with the same expiry date. As an example, in this case we sold a put with a $45/share strike price and we purchase a put with a $43/share strike price. Because the put we purchased has a lower strike price, it will cost less than the put we sold – known as a net credit. Now, if the stock suddenly drops to $35/share we are forced to purchase it for $45/share but we’ve acquired the right to sell it for at least $43/share – thereby limiting our loss to $2/share (commissions are not factored in yet).
You can increase you net credit by buying a put with an even lower strike price, but note that you are increasing your potential loss. Funny how this “risk and return” concept crops up everywhere no matter where you look… :)
So who would use this? One situation would be an investor who is willing to accumulate stock but wants to get paid to wait for prices to come down a little bit more, while at the same time guarding against the risk of a quick and severe collapse in the stock’s price. They must also accept that they may miss out on the opportunity to acquire the stock.
More to come…
Disclaimer: option trading can be conservative or risky – it pays to take some time and educate yourself. A great start would be to check out Mark Wolfinger’s “The Rookie’s Guide to Options” before getting started with option trading.