Wednesday, 8th September 2010

Writing Puts

Written by George Traganidas Topics: Articles, Options, Wealth Building

Fool.com
By Jeff Fischer
August 10, 2009

Why write puts?

  • Income: To make money while waiting for your preferred buy price on a stock.
  • Advantage: To buy stocks at a lower net cost.
  • Profit: To earn income from stocks you believe will hold steady or increase modestly.

Foolish facts to know:

  • The trade command is usually “sell to open,” and you’re paid the option’s premium the moment you make the trade. That money is yours to keep, but its value will fluctuate in your account until expiration.
  • Unlike covered calls, you do not need to own the underlying stock to write a put. It’s the opposite, in fact: You write puts on stocks you’d like to own at lower share prices. Before you write a put, you need to be ready and willing to buy the underlying stock in the future.

Now that you’ve learned the basics of calls and puts in Options for Beginners and studied covered call strategies in Writing Covered Calls, it’s time to up the ante with our next lesson: how to sell, or “write,” put options for better prices on stocks you’d like to buy — or for income if your buy price doesn’t materialize.

Let’s say a stock trades at $18, and you’d be a happy buyer at $15 or below. In this case, you can write (“sell to open”) put options with a $15 strike price. You sell one put for every 100 shares of stock you’d like to buy, and you’re paid the option premium — $1 per share in this example — and are now on the hook to buy shares if they fall.

If the stock drops to $15 or lower by the option’s expiration, you’ll be “put” (sold) the shares to your account. Including the $1 option premium you were paid, your net buy price on the stock is $14, a great start price. Now, if the stock isn’t below $15 by the expiration date, the options simply expire — meaning you don’t get to buy shares, but you’ve made income (the $1 per share) in the meantime and can write puts again for a future month.

When to Write Puts

Put writing is a bullish, or at least neutral, strategy. When you write a put, you’re saying you believe the underlying stock will eventually increase in price (hopefully after you’ve bought shares), or at least hold steady — meaning you’ll earn income on your puts when they expire.

Let’s use an example: Assume you’re bullish on Stock XYZ. The stock increased from $20 to $25, so you’re not as anxious to buy it. If the shares fell to $22 or so, however, you’d be happy to buy. Rather than just sit and wait, you can write (remember, that’s “sell to open”) the $22.50 strike price put options. You’ll get paid while you wait, and you’ll potentially get that lower buy price.

Before placing this trade, make sure you have the cash (or, for experienced investors, ample buying power) in your account to buy a minimum of 100 shares. You can then write $22.50 puts that expire in a few months. Let’s say the puts pay you $1.50 per share, and you write two contracts representing 200 shares. You’re paid $300 (minus commissions) up front. And now you wait (cue the Jeopardy theme).

If Stock XYZ ends this time period above $22.50, your options simply expire, and you keep the $300. You can then write new puts if you’d like. If the stock dips below $22.50 at the option’s expiration, the puts you wrote will be exercised, and you’re on the hook to buy 200 shares at a strike price of $22.50. Including the option premium you received, your start price is actually $21. Nice! Now you own shares at an attractive start price and can wait for appreciation.

So, you write puts when:

  • You’re ready and willing to buy a stock at a lower price and
  • You don’t believe the stock will soar away from you in the meantime (otherwise you’d just buy the stock), or

You just want to make income writing puts. You don’t believe a stock will drop to your buy price, but if it does, you’d still be happy to buy it.

8 Tips for Writing Puts

1. Always choose a strike price at which you’d be happy to buy the stock.
2. Focus on strong businesses that you’d be excited to own for the long term.
3. Write “out-of-the-money” puts, meaning your strike price is below the stock’s current share price.
4. Verify that the option premium payment makes the trade worthwhile.
5. Remember, you often won’t get to buy the stock; you’ll just get option income. That’s why we sometimes write puts on stocks in which we already own partial positions.
6. Put writers do not collect dividends paid by the underlying stock.
7. Never overextend yourself by writing too many puts. Brokers allow put writing on margin, but we write puts when we have the cash to buy the stock.
8. Vary the expiration dates among your individual option holdings so they don’t all fall in the same month — this staggers your risk.
9. You may write “in-the-money” puts with strike prices above the current share price when you’re especially bullish on a stock and want to capture more upside potential with its options. This strategy also increases the odds that you get to buy the stock. When you write in-the-money puts, the guidelines in our table don’t apply.

What Can Go Wrong?

Sounds perfect, doesn’t it? You’re paid to potentially buy a stock you wanted to buy anyway — and at a price you like. That’s beautiful.

But every investing strategy has some risk. In this case, assume Stock XYZ doesn’t fall below $22.50 by the time your option expires, but instead jumps to $30 over the next few months. You miss out on a $5 stock gain for only a $1.50 gain in the put options, and you still don’t own shares. Now what do you do? It might be a tough call.

The stock could also drop to $22 soon after you write your puts, but then climb back to $25 just as your puts hit their expiration date. Because almost all options are exercised only at expiration, you won’t get the shares, and you will have missed your buy price. Of course, you keep the $1.50 option premium and can write new puts, but what if you miss your buy price again?

There’s also the scenario that the stock drops and doesn’t come back up for a long time. If the stock fell to $17, your options would be far underwater. In this case, you must be ready to just buy the stock at your net price of $21 and hope for a rebound. At least you’re getting a much lower start price than if you had simply bought the stock outright at $25 on day one.

But if you no longer wanted to own Stock XYZ even at $17 — say there’s a fundamental change in the business — you would need to buy back your puts (“buy to close”) early — and at a large loss. So, Fools, whenever you write puts, be confident that you want to own the stock for the long haul.

Make Put Writing Worthwhile

When you like a stock enough to want to own it, be as certain as possible that it’s a good strategy to write puts rather than just buying the shares outright. In general, don’t write puts when you believe a stock is greatly undervalued and about to take off — just buy the stock. Write puts when you believe a stock is a good buy at a certain price yet is unlikely to leave you in the dust if you don’t buy it anytime soon.

Once you’ve identified a put contender, calculate whether the options are paying you enough to make the risks worthwhile. Weigh both the risk of waiting to buy the stock instead of buying today (missing potential upside) and the risk if the stock falls sharply.

You want a large enough cushion on your puts to ensure a much better valuation on the stock you’ll potentially buy. At the same time, you want enough payment from the options to make the trade worth your wait. The table below shows what to generally seek on options expiring in four months or longer versus those that expire in a few months:

Factor to Consider Options Expiring in 4 Months or More Options Expiring in 3 Months or Less
Strike price Strike price should be at least 7% below current stock price. Strike price should be at least 4% below current stock price.
Trade’s break-even price (your strike price minus the option premium paid to you) At least 14% to 17% below current stock price. At least 8% to 9% below current stock price.
Option premium payment At least 7% to 10% of your strike price. (This is also your return on the cash you’ll be keeping aside for the possible stock buy.) At least 4% to 5% of your strike price.
Target time frame until option expiration No more than 9 months; ideally, 6 months or less. For the above figures, ideally, 3 months or less.

Now let’s apply these guidelines to an example. As of Nov. 11, 2008, Stock XYZ was trading at $24.35 per share — but let’s say you’d prefer to buy in the low $20s. The $22.50 January options, which expire in just two months, are bidding at $2.20 per share. The strike price of $22.50 is 7.6% below the stock’s current price of $24.35, and the option premiums pay a solid 9.7% of your potential purchase price ($2.20 on a $22.50 strike price). Your break-even price if you get the shares is just $20.30 — 16.6% below the current share price.

These numbers are great, especially for an inexpensive-looking stock and options that expire in less than three months. Even if you don’t get the shares at expiration, you’ll earn $2.20 per share in two months, or nearly 10% on the cash you have set aside for this trade.

Closing Early and Rolling Forward

If you no longer want to potentially buy the underlying stock, or if you’ve made most of your potential profit on the options, you can close your puts early. Just “buy to close” the puts you sold earlier; you’ll pay the going market price, resulting in a gain or loss dependent upon what you were paid for the puts at the start. In most cases, we won’t close a put early at a loss unless we’re certain that we don’t want to own the underlying stock anymore — which would mean our analysis was mistaken from the beginning or something drastically changed at the company.

You can also choose to close your put-writing strategy early to write new puts that expire in a later month, paying you a higher option premium. You might do this if you’ve made most of the money you can possibly earn on the trade (about 85% is our guideline); if you want more time for your strategy to play out; or if you simply want to be paid more now for keeping the strategy in place, for any reason. This is called “rolling forward.” Just make sure you can find attractive new puts to write before closing your old ones.

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