Understanding Puts
18 Feb 2018

Understanding Puts

Put option is the contract giving the

18 Feb 2018

Put option is the contract giving the owner the right to sell a stoc0k at any security at a specified price within a specified time.

A put is bought (long) when the outlook for the stock is bearish.

A put is sold (short) when the outlook for the stock is bullish.

Put premium rises when the stock declines.

Put premium declines when the stock rises.

In general one put contract controls 100 shares.

Understanding Naked Puts

A naked put (uncovered put) is a put option where the option writer (seller) does not have sufficient funds in his trading account to cover the puts (buy stock) in case the stock is assigned to him. When a trader is putting on naked put strategy, his outlook on the stock is bullish and he is “assuming” that puts will expire worthlessly and he will keep the premium. But this is a dangerous assumption. Stock can decline suddenly, the puts he sold will rise in value and he will receive a margin call to provide cash to buy the stock which is declining.

Understanding Cash-Secured-Puts Strategy

When an investor sells puts, he must have enough money in his brokerage account to actually buy the stock. We call this a “cash-secured-put-sale”.

If an investor has the money, and has identified a stock which he thinks will rise in future but does not want to buy the stock at current price rather on pullback then selling cash-secured pus is worth considering. He can sell puts that expire in one month or three months with prices 5% to 10% below the associated stock’s price.

Suppose an investor wants to buy 100 shares of FB (FaceBook). Let’s suppose FB is trading 10% below its 52-week high and investor thinks the selloff is overdone and the bottom is forming in FB.

Let’s assume FB is trading at $107 and it looks like that there is the high probability that FB will rise from the current level, however, there is slight chance it can fall to $100 level (which is strong support).

Therefore, Instead of buying 100 shares of FB outright at $107 an investor can sell one contract of December 105 Puts that is bidding at $3.00. Thus collecting $300 (minus commission). If the investor’s assumption is correct that FB has bottomed and is due to rise upward then FB will be rising and the Puts price will be declining from $3.00 level.

As FB continues its rise, the price of Puts will keep declining and eventually, the Puts will expire worthlessly and investor keeps the whole premium which is $300 per contract and investor will make a decent return on his investment. (The investor needs to have a margin account and the funds in his account to purchase FB stock in case FB falls.)

On the other hand, let’s assume that FB does not stop declining at $107 and keeps falling down and goes to $100 by December expiry (third Friday of the month). The puts that an investor sold for $300 will rise in price. If the investor keeps the Puts and does not close out then he will be assigned 100 shares for each contract of Puts at $100 per share (because he had sold puts of 100 strike). Since he has collected $300 earlier by selling the Puts the investor net cost of FB would be $9700 for 100 shares instead of $10,000.

In summary, instead of buying FB shares outright at $107 an investor whose outlook on FB or any stock is bullish can sell the puts – thus collect the premium. If the stock rises, he gets to keep the premium.

In other words, the investor is getting paid to buy the stock at below market price.

If the stock falls to support such as $100 he is assigned the stock at discounted price.

The investor in our example will start losing money on investment if FB goes below $97.00 (break even point).

The above described strategy is for those investors who are planning to buy certain stock due to the bullish outlook and have identified the support levels correctly.

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