Money Doesn’t Come Without Guidence ...
You've likely encountered a situation where you find a stock you would like to invest in but a recent run up in price makes you question whether it is overvalued. You tell yourself that you'd buy it if the price drops a percent or two. Maybe the stock does not come back to your target and you miss out on an opportunity.
This may be a situation in which you could consider selling short or writing a put option rather than placing a stock limit order. The short put may allow you to get in at a lower cost basis, while providing some profit if the stock price continues to rise. Here's how it works:
When you short a put, you take on the obligation to buy shares at the put option strike price.
This will occur if the stock is below the put strike price at the expiration of the contract, and it fits with a goal of buying the stock if it were to drop to a target price. If the stock does not fall below the put strike price of the contract, then contract expires as worthless, and the put seller keeps the premium.
Let's look at a hypothetical example. Company XYZ just came out with the latest and greatest widget. The price of the stock soars to $100 after the announcement. You want to buy the stock but feel that the price has gone too high because of the hype around the widget. You'd be willing to buy the stock for $95.
The following are quotes for XYZ put options.
The put contract obligates the put seller to buy the shares of stock at the strike price of the put. On the surface you'd think you should look to the $95 strike price put. However, you need to take into consideration the $2 per share premium received when selling the put. The table shows that selling the $97 strike put for $2 gives us an effective buying price on the stock of $95.
Let's look at the profit/loss diagram to graphically parallel selling the $97 strike put compared to buying the stock. The blue line represents the profit or loss of a stock-only position, and assumes you buy the stock at $100 per share. The red line represents the profit or loss of a short put position.
If the stock is below $97 at the contract expiration, you will be obligated to buy shares of stock from the put owner for the $97 contract strike price. The effective purchase price on the shares is $95 since you received a $2 payment up front. At $95 per share, you have the same downside risk of stock ownership. This is evident by the parallel red and blue lines.
If the stock price is above $97 at time of the contract expiration, the owner of the contract would not exercise the contract since he would able to sell the stock at a higher price in the open market. The contract would expire worthless. This leaves the put seller with a $2 per share profit from the premium received. Of course, the seller would not own the stock, and would not profit from the increase in the price of the stock.
This illustration is hypothetical and does not reflect actual investment results or guarantee future results.
You are able to sell short or write a put if your account is approved for option trading.
In a cash account, you will be required to hold enough cash to buy the underlying security. The typical option contract represents 100 shares of stock, so in the example above, you have been required to hold $9,700 ($97 x 100). This cash cannot be used for other activities until the short put position is closed.
In a margin account, you can short a put with an uncovered or “naked” margin requirement. This requirement is typically much less than the cash-secured requirement, but you have the same obligation to buy shares for $97 per share. Margin leverage increases purchasing power and possible rate of return, but it can also expose you to higher losses.
Additionally, the margin requirement will increase if the stock price drops. This could lead to a margin requirement greater than the equity in your account (margin call). Such situations will require you to deposit more money, close the position or force the sale of other securities in your account. Trading naked options has a higher level of risk and requires a greater level of expertise and attention.