Writing Puts to Purchase Stocks

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Introduction to Put Writing

A put is a strategy traders or investors may use to generate income or buy stocks at a reduced price. When writing a put, the writer agrees to buy the underlying stock at the strike price if the contract is exercised. Writing, in this case, means selling a put contract in order to open a position. And in exchange for opening a position by selling a put, the writer receives a premium or fee, however, he is liable to the put buyer to purchase shares at the strike price if the underlying stock falls below that price, up until the options contract expires.

Profit on put writing is limited to the premium received, yet losses can be rather substantial, should the price of the underlying stock fall below the strike price. Due to the lopsided risk/reward dynamic, it may not always be immediately clear why one would take such a trade, yet there are viable reasons for doing so, under the right conditions.

Key Takeaways

  • A put is an investment strategy that’s employed by traders who seek to generate income or purchase shares of stock at a discounted price.
  • When writing a put, the writer consents to purchasing the underlying stock at the strike price, but only under certain conditions. Mainly, the contract must be exercised.

Put Writing for Income

Put writing generates income because the writer of any option contract receives the premium while the buyer obtains the option rights. If timed correctly, a put-writing strategy can generate profits for the seller, as long as he is not forced to buy shares of the underlying stock. Thus, one of the major risks the put-seller faces is the possibility of the stock price falling below the strike price, forcing the put-seller to buy shares at that strike price. If writing options for income, the writer’s analysis should point to the underlying stock price holding steady or rising until expiry.

For example, let’s say XYZ stock trades for $75. Put options with a strike price of $70 are trading for $3. Each put contract is for 100 shares. A put writer could sell a $70 strike price put and collect the $300 ($3 x 100) premium. In taking this trade, the writer hopes that the price of XYZ stock stays above $70 until expiry, and in a worst-case scenario at least stays above $67, which is the breakeven point on the trade.

We see that the trader is exposed to increasing losses as the stock price falls below $67. For example, at a share price of $65, the put-seller is still obligated to buy shares of XYZ at the strike price of $70. He, therefore, would face a $200 loss, calculated as follows:

$6,500 market value – $7,000 price paid + $300 premium collected = -200

The more the price drops, the larger the loss to the put writer.

If at expiration the price of XYZ is $67, the trader breaks even. $6,700 market value – $7,000 price paid + $300 premium collected = $0

If XYZ is above $70 at expiration the trader keeps the $300 and doesn’t need to buy the shares. The buyer of the put option wanted to sell XYZ shares at $70, but since the price of XYZ is above $70 they are better off selling them at the current higher market price. Therefore, the option is not exercised. This is the ideal scenario for a put option writer.

Writing Puts to Buy Stock

The next use for writing put options to get long a stock at a discounted price.

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Instead of using the premium-collection strategy, a put writer might want to purchase shares at a predetermined price that’s lower than the current market price. In this case, the put writer could sell a put with a strike price at which they want to buy shares.

Assume YYZZ stock is trading at $40. An investor wants to buy it at $35. Instead of waiting to see if it falls to $35, the investor could write put options with a $35 price.

If the stock drops below $35, selling the option obligates the writer to buy the shares from the put buyer at $35, which is what the put seller wanted anyway. We can assume that the seller received a $1 premium from writing the put options, which is $100 in income if they sold one contract.

If the price falls below $35, the writer will need to buy 100 shares of stock at $35, costing a total of $3,500, but they already received $100, so the net cost is actually $3,400. The trader is able to accumulate a position at an average price of $34; if they simply bought the shares at $35, the average cost is $35. By selling the option, the writer reduces the cost of buying shares.

If the price of the stock remains above $35, the writer will not have the opportunity to buy the shares, but still keeps the $100 in premium received. This could potentially be done multiple times before the price of the stock finally falls enough to trigger the option to be exercised.

Closing a Put Trade

The aforementioned scenarios assume that the option is exercised or expires worthless. However, there is an entire other possibility. A put writer can close his position at any time, by buying a put. For example, if a trader sold a put and the price of the underlying stock starts dropping, the value of put will rise. If they received a $1 premium, as the stock is dropping, the put premium will likely begin rising to $2, $3, or more dollars. The put seller is not obliged to wait until expiry. They can plainly see that they’re in a losing position and may exit at any time. If option premiums are now $3, that is what they will need to buy a put option at, in order to exit trade. This will result in a loss of $2 per share, per contract.

The Bottom Line

Selling puts can be a rewarding strategy in a stagnant or rising stock since an investor is able to collect put premiums. In the case of a falling stock, a put seller is exposed to significant risk, even though the profit is limited. Put writing is frequently used in combination with other options contracts.

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount.

So, instead of entering a limit order to purchase the stock, you can write an equivalent amount of near-month slightly out-of-the-money naked puts with a strike price that is equal to the target price at which you wish to purchase the underlying stock.

Thereafter, on expiration date, if the stock price and your sentiments towards the underlying stock remains unchanged, the puts that you sold will expire worthless. This lets you pocket the premiums received and write some more put options.

Should the stock price take a dive and goes below the put strike price, you can either follow through with your obligation and pickup the stock or you can buy back the put options at a loss. The decision you make will depend on whether your outlook towards the underlying stock has changed since taking up the position.

You should probably buy back the put options at a loss if a significant piece of bad news had surfaced which negatively impacted the fundamentals of the underlying stock, causing you to be no longer bullish on the stock. The premiums that you received should help to cushion some of the losses.

Otherwise, if the drop in stock price is minor and your target price is hit, you will be able to buy the stock at a reasonable discount along with the extra premiums received from the sale of the put options.

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Writing Put Options – How to Buy Stocks at a Discount by Writing Put Options

Option traders have an advantage over stock traders because, when the timing is right, they can buy stocks at a discount. How do they do it? They sell put options on stocks they want to own and then wait for the price to fall. Sound complicated?

Surprisingly, it’s quite simple once you understand the basics. Let’s start from the top and take a look at the first step you need to take to start putting this strategy to use in your own portfolio.

Step 1: Find a Stock You Want to Own

The first step to take when looking to buy stocks by selling puts is to find a stock that you would like to own. After all, in the end when you employ this strategy, you are hoping to own the stock as a part of your portfolio. And since you wouldn’t just go out and buy any old stock in a standard stock trade, you shouldn’t just settle for any old stock when implementing this strategy.

This may seem obvious, but when we get into the next step, you will see that if you don’t start with Step 1, it is easy to be tempted to simply sell puts on the stocks that are offering the highest premium–which can be a big mistake.

When you’re looking for stocks you would like to own, make sure you look for stocks with strong fundamentals–especially in turbulent markets because they have a good chance of rebounding faster than other stocks.

Step 2: Sell Put Options

Your next step to buying stocks at a discount is identifying which put option you are going to sell and then selling it. As an option seller, you have three choices when looking at which put option to sell. You can sell the at-the-money option, an out-of-the money option or an in-the-money option.

When selling puts to buy stocks, you are typically going to use an at-the-money put option. At-the-money options offer a nice balance between paying a good premium and giving you a good chance of actually having the stock put to you.

The premium you receive for selling the put option directly impacts the discount you will get on your stock purchase if the stock is put to you. The higher the premium, the better the discount. As I mentioned above, some stocks offer extremely high premiums on their put options either because the stocks are extremely volatile or everybody believes the stock is going to be moving lower. If you haven’t done your homework and determined that the stock is one you would want to own, you may be tempted to go for the stock with the highest premium.

Step 3: Manage Your Trade

Once you have sold your put option, it is time to sit back and see what happens to the price of the stock. Basically, one of the following four things can happen to the price of the stock:

– The stock price can go up
– The stock price can stay where it is
– The stock price can go down a little
– The stock price can down a lot

Let’s take a look at what would happen in each scenario.

The Stock Price Goes Up — If the stock price goes up after you sell the put option, you don’t have to do anything. The put you sold will expire worthless, and you get to keep the premium you received when you sold the put.

The Stock Price Stays Where It Is — If the stock price goes up after you sell the put option, you don’t have to do anything. The put you sold will expire worthless, and you get to keep the premium you received when you sold the put.

The Stock Price Goes Down a Little — If the stock price goes down a little, the person who bought the put from you may choose to exercise the option, and you will have to buy the stock at the strike price set in the option. But since you sold the put on a stock you wanted to own anyway, this is a terrific result. You now own the stock you wanted, plus, you get to keep the premium you received when you sold the put.

The Stock Price Goes Down A Lot — If the stock price goes down a lot (below your breakeven point), the person who bought the put from you will definitely choose to exercise the option, and you will have to buy the stock at the strike price set in the option. But once again, since you sold the put on a stock you wanted to own anyway, this is a terrific result. You now own the stock you wanted, plus, you get to keep the premium you received when you sold the put.

Of course, if you see the stock dropping below your breakeven point, and you decide you don’t want to buy the stock after all, you can always buy back the put you sold and exit the trade.

This market is packed with opportunities to make big money … if you know where to look. Find the hidden money-doublers in today’s stock market. Learn more in your FREE Options Report.

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