A “put” is an option contract giving the owner (buyer) the right, but not the obligation, to SELL the underlying stock at a set price within a specified time. The BUYER of a put bets that the underlying stock will drop below the exercise price before the expiration date. BUYING a put is similar to taking a short position because it is betting the stock goes down, and paying for the right to sell it at a higher price.
SELLING a put is similar to taking a long position because the SELLER is promising to buy the stock at a lower price if the stock drops below that price. The put seller is betting on higher prices, and agreeing to buy the stock at a lower price if it drops.
By a “naked put,” we mean there is no offsetting short position in the stock. A securities position that is not hedged from market risk is “naked.” A covered position is hedged from market risk. Potential gain and potential risk are greater when a position is naked vs. covered. (Investopedia)
Courtesy of Paul Price
One of life’s beautiful equations is the way certain seemingly unrelated transactions can effectively be balanced in terms of risk/reward. Most investors are entirely comfortable selling covered calls on shares they own. Many of these same traders would never consider selling (writing) naked puts on the same underlying company.
A covered call is a call written (sold) against an underlying long position in a stock. For example, if we own 100 shares of ESRX, we can write one covered call against it. Each call represents 100 shares of stock. A put is a contract to sell 100 shares of stock at a certain price, the strike price.
These option strategies are largely equivalent.
Let’s analyze these two situations separately. I’m going to use one of our Virtual Value Portfolio components, Express Scripts (ESRX), in my example. The same theory would apply to any underlying shares and the associated options.
We could buy 100 ESRX @ $53.82 while selling a Jan. 2014 $55 call for $4.80 /share. Our net out-of-pocket expense would be $53.82 – $4.80 = $49.02/share.
Maximum upside: If ESRX closes at $55 or above on Jan. 17, 2014. The call would be exercised. We would sell our 100 shares for $5,500 total. Writing (selling the call) limited our upside to $55/share by obligating us to sell at $55 even if ESRX is trading higher.
If ESRX reaches $55 or higher, we sell it at $55 and make $1.18 on the stock; we keep the $4.80 for selling the now worthless call. That’s a profit of $5.98/share on a $49.02/share outlay – a 12.2% gain.
Investors could liquidate at expiration with a $4.80 per share gain even if ESRX stays at $53.82. That represents a 9.8% cash-on-cash profit on a stock that went nowhere. We keep the $4.80 for selling the call, and we keep the stock if the price is less than $55 at expiration.
Break-even: If ESRX remains below $55 on expiration date, we would break-even with ESRX at $49.02 (our initial outlay). That would be 8.9% below the price of ESRX when we initiated the trade. If ESRX is above $49.02, we make a profit.
Worst-case scenario: If ESRX goes to zero, we would lose $49.02 per share.
In summary: Buying 100 shares and selling one call leaves traders with limited upside (+ 12.2%) and moderate downside protection – up to an 8.9% drop in share price from the trade’s inception would cause no loss. Maximum risk was reduced from $53.82 (the original purchase price) to $49.02 per share.
Instead of buying 100 shares of ESRX and selling one call, let’s simply SELL one Jan. 2014 $55 put for $5.85. Selling a put has the following risk/reward profile:
Maximum profit: If ESRX closes at $55 or higher on Jan. 17, 2014. Express Scripts needs to rise by 2.2% or more for the short put to expire worthless. We would then keep the entire $5.85 premium per share ($585 per contract) with no further obligation.
Break-even, or better, is possible on a drop to no lower than $49.15. Break-even is at $49.15. ESRX could fall 8.6% below its price at the trade’s inception, $53.82, without turning into a loss.
If ESRX remains unchanged from the original price on option expiration day, the put sellers could keep almost 80% of the original premium received by simply closing out the put just prior to expiration.
Maximum risk: $49.15 /share. That would mean ESRX became totally worthless.
Prem = premium (the amount collected from selling the put)
Both techniques offer very similar trade profiles.
Margin, and cash requirements and tax treatments would vary more than the actual risk/return ratios. I use both ways to structure option trades on a regular basis.
Disclosure: Long ESRX shares
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