Sell Put-Similarities to the Covered Call Strategy

Selling a put has many similarities to the covered call strategy. We’ll discuss the two positions and highlight the likenesses. Chapter 6 will detail the nuts and bolts of why these similarities exist.Consider an example of selling a put:Sell 1 BA January 65 put at 1.20 In this example, trader Sam is neutral to moderately bullish on Boeing (BA)
between now and January expiration. He is not bullish enough to buy BA at the current market price of $69.77 per share. But if the shares dropped below $65, he’d gladly scoop some up. Sam sells 1 BA January 65 put at 1.20.

The at-expiration diagram in Exhibit 1.5 shows the P&(L) of this trade if it is held until expiration.At the expiration of this option, if Boeing is above $65, the put expires and Sam retains the premium of $1.20. The obligation to buy stock expires with the option. Below the strike, put owners will be inclined to exercise their option to sell the stock at $65. Therefore, those short the put,as Sam is in this example, can expect assignment.

The break-even price for the position is $63.80. That is the strike price minus the option premium. If assigned, this is the effective purchase price of the stock. The obligation to buy at $65 is fulfilled, but the $1.20 premium collected makes the purchase effectively $63.80. Here, again, there is limited profit opportunity ($1.20 if the stock is above the strike price) and seemingly unlimited risk (the risk of potential stock ownership at $63.80) if Boeing is below the strike price.

Why would a trader short a put and willingly assume this substantial risk with comparatively limited reward? There are a number of motivations that may warrant the short put strategy. In this example, Sam had the twin goals of profiting from a neutral to moderately bullish outlook on Boeing and buying it if it traded below $65. The short put helps him achieve both objectives.Much like the covered call, if the stock is above the strike at expiration,this trader reaches his maximum profit potential—in this case 1.20.

And if the price of Boeing is below the strike at expiration, Sam has ownership of the stock from assignment. Here, a strike price that is lower than the current stock level is used. The stock needs to decline in order for Sam to get assigned and become long the stock. With this strategy, he was able to establish a target price at which he would buy the stock. Why not use a limit order? If the put is assigned, the effective purchase price is $63.80 even if the stock price is above this price.

If the put is not assigned, the premium is kept.A consideration every trader must make before entering the short put position is how the purchase of the stock will be financed in the event the put is assigned. Traders hoping to acquire the stock will often hold enough cash in their trading account to secure the purchase of the stock. This is called a cash-secured put.

In this example, Sam would hold $6,380 in his account in addition to the $120 of option premium received. This affords him enough free capital to fund the $6,500 purchase of stock the short put dictates. More speculative traders may be willing to buy the stock on margin, in which case the trader will likely need around 50 percent of the stock’s value.Some traders sell puts without the intent of ever owning the stock.

They hope to profit from a low-volatility environment. Just as the short call is a not-bullish stance on the underlying, the short put is a not-bearish play.As long as the underlying is above the strike price at expiration, the option premium is all profit. The trader must actively manage the position for fear of being assigned. Buying the put back to close the position eliminates the risk of assignment.