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May
2006
When writing put options, the investor must be prepared to actually
acquire the shares underlying the put options if he is assigned by the
put option holder. Thus, he “secures” his put options by
a cash deposit or by the proceeds of short-selling the stock. Even
with such a constraint, writing put options can still be a useful means
of acquiring stock at below market prices. Indeed, many investors prefer
to write put options rather than place limit buy orders at below market
rates and wait for a “fill” if the stock should drop in value.
To allow an investor to acquire stock at a net cost below market price.
This strategy also increases the return of a portfolio because of the
premium received.
On April 11, 2006, XYZ shares are trading at $27.00.
An investor feels the shares are slightly overvalued in the present market
but is very positive regarding XYZ shares over the long term. Instead of
putting in a limit order to buy XYZ at $25.00 per share, he decides
to write put options with an strike price of $25.00. Accordingly,
the investor writes ten XYZ JUN 25 put options at a premium of $1.15
per share. His revenues are $1,150.00.
Scenario 1: XYZ’s stock price drops
below $25.00.
At the put option’s expiration on June 20, XYZ shares are at $24.00.
The investor is “assigned” to take delivery of XYZ shares
at $25.00 since the holder of ten XYZ JUN 25 put options decided to exercise
his options. As a result, the investor acquires 1,000 shares of
XYZ at a net effective price of $23.85 (i.e. $25,000.00 for the 1,000
shares “put to him” at $25.00 each, less the previously received
revenue of $1,150.00), which is still below the prevailing market price
of $24.00 and well below the price of XYZ shares on February 11. If the
XYZ shares drop below $23.85 (i.e. strike price less premium on February
11), the investor may be obliged to buy XYZ shares at a price that is
suddenly well above market prices. This could result in large losses
if he did not close out his ten short XYZ JUN 25 put options position.
Note that, in the case of the uncovered sale of put options, the investor
has large downside risks if the stock falls substantially. He will therefore
have a significant opportunity cost, since the strike price is higher
than the stock market price.
Scenario 2: XYZ’s stock price stays
above $25.00.
The investor retains his option premium revenues but might regret not
having purchased XYZ shares on February 11 at $27.00. He will be in
a net favourable situation, however, so long as XYZ shares remain below
$28.15 (i.e. February 11 price of $27.00 plus premium of $1.15). Here,
the uncovered investor will realize the same profit as the covered
investor since both options will expire worthless and will not be assigned.
*Investors should review the document that describes
the risks inherent in negotiating options.
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