Understanding Writing Put Options

If you choose to exit the position before expiration, you may need to repurchase the option at a price higher than what you initially sold it for. Upon exercise, the potential loss can be significant if the underlying asset’s price drops below the put’s strike price. Given these risks, along with the complexities of margin requirements, writing puts is a strategy best suited for seasoned investors.

Investor objectives

Investors who write puts often do so to generate additional income. If you have a neutral to bullish outlook on a particular stock or index, you can sell a put on that underlying asset and receive a premium in return. If the asset’s price doesn’t fall below the strike price, the option will likely expire unexercised, allowing you to keep the premium as your profit.

For instance, let’s say you believe that XYZ stock, currently trading at $52, won’t drop below $50 in the next few months. You could write an XYZ put option with a $45 strike price, expiring in six months, and sell it for $200. If XYZ’s price rises, stays the same, or even drops to $46, your option remains out-of-the-money, allowing you to keep the $200 premium.

A more conservative approach to put writing involves combining this options strategy with stock ownership. If you have a target price for a stock you’d like to own, you can write put options at a strike price you find acceptable. You’ll receive the premium upfront, and if the option is exercised before expiration, you’ll be obligated to purchase the shares. The premium received reduces your net cost for the shares.

For example, if XYZ stock drops to $42, your short put with a $45 strike price is now in-the-money. If assigned, you’ll need to buy the stock for $4,500. However, the $200 premium you received offsets this, bringing your total outlay to $4,300, which equates to a net price of $43 per share. If the stock price rises in the future, you could see substantial gains. Alternatively, you could close out your position before assignment by buying back the put. However, since the option is now in-the-money, the cost to repurchase it may exceed the premium you initially received.

Calculating return

If you write a put option and it expires unexercised, calculating your return might seem straightforward: subtract any fees and commissions from the premium you received. However, writing puts typically requires a margin account with your brokerage firm, so it’s important to factor in any capital that was held in that account, as it could have been invested elsewhere during the life of the option.

For example, if you write the XYZ 45 put, you would receive $200. However, your brokerage firm would likely require you to hold that premium, along with a percentage of the $4,500 needed to purchase the shares, in reserve in your margin account. While the capital is still yours, it remains tied up until the put expires or you close out the position. If the put is exercised, the premium you received when you opened the position reduces the amount you pay for the shares when you fulfill your obligation to buy.

In the case of the XYZ 45 put, the $200 premium reduces your purchase cost from $4,500 to $4,300, resulting in a cost basis of $43 per share plus commissions if you decide to hold the shares in your portfolio. If you choose not to hold the shares and sell them in the stock market, selling them for less than $43 per share would result in a loss.

Understanding Writing Put Options by Inna Rosputnia

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