Strategies in Covered and Uncovered Put Writing
Writing covered or uncovered put options can also be profitable. In writing a put option, the writer can be obligated to buy 100 shares of stock at the strike price any time before the expiration period. In exchange for assuming this risk, the holder of the put option pays a premium for that put option. You are considered a covered put writer if you own the equivalent short stock position or if you have deposited to your broker the amount of money that is the equivalent of the exercise price. The advantage of being a covered put writer is that you get to earn profits from the premium paid as well as from the difference between the amount of the strike price and the amount of the original stock price of the short position. The possible loss that you may incur would be when the stock price increases beyond the original stock price of the short position.
A put is considered uncovered if the writer does not own the equivalent short stock position or if he does not deposit to his broker the equivalent amount of the exercise value of the put option. Investors choose to write uncovered put options because they want to earn the premium paid for the put option and the possibility that they may own the 100 shares of stock at a price lower than the fair market value of the stock. I will utilize an illustration to elaborate. Note, however, that for purposes of simplicity, tax considerations, commissions as well as transaction costs have been omitted in my illustrations. Also, the put options here are assumed to be American style, which means that the put option can be exercised any time before the expiration period.
Let us assume that you write a Stock C July 55 put for the value of $5 as premium. This means that you may be obligated to buy 100 shares of Stock C at $55 each before the expiration date in July. Let us assume that before July, the price of Stock C drops from $55 per share to only $45 per share. The put option may be exercised and hence you are forced to buy 100 shares of Stock C at $55 each garnering a total loss of $5,000 ($5,500 – $500 premium). You can then re-sell these 100 shares of stock at the prevailing market value of $4,500 thereby further cutting your losses to only $500.
If the stock prices of Stock C plummets to only $52 per share, the put may still be exercised but al least you can re-sell the stocks for $5,200 thereby profiting $200. But if the stock price of Stock C remained only at $55, the put probably will not be exercised and you earn $500. As one can see, both covered and uncovered call may be risky, but despite the risks, put writers can still earn profits from the premium paid and depending on the decrease of the stock prices, even earn from the exercise of the put.