Subject: Strategy - Writing Put Options To Acquire Stock
Last-Revised: 22 Aug 2000
Contributed-By: Michael Beyranevand (mlb2 at Bryant.edu)
Is there a stock that you would like to purchase at a cheaper price than its current quote? Would you be interested in receiving premiums months before you have to purchase the stock? If these propositions sound attractive to you, then writing puts to acquire stock is a strategy you should consider in the future. This article explains the entire procedure, as well as the associated risks and rewards.
When you write a put option you are giving the buyer of that option the right (but not the obligation) to sell their stock to you at a predetermined price at any time until a certain date. For giving the buyer this luxury, he or she will in turn pay you a premium at the time you write (i.e., sell) the option. If the buyer decides to exercise the option then you must purchase the stock; conversely, if the option expires unexercised then you still have the premium as your profit.
Let's work through an example. Let's say that you are bullish on Ebay.com for the long-term with the current value of the stock at $52. One option would be to fork over $5,200 and purchase 100 shares of the stock and just hold on to them. Another option however would be to write a Jan 01 45 put option, which is trading at about $8.50. This means that at anytime between now and the third Saturday in January, you might have to purchase 100 shares of E-Bay at $45 a share. For doing this you are compensated $850 upfront (100 shares times $8.50).
Come January, one of two situations will occur. If the option has not been exercised by then, your obligation is over and you have a profit of $850. If the option is exercised (if you are put, to use the jargon), you would pay $4,500 to own the 100 shares of the stock. After taking into consideration that you were already paid a premium of $850, the true cost for the 100 shares of E-Bay is only $3,650 or $36.50 a share. You would in essence be purchasing the shares at a 30% discount to what you would have normally paid had you just bought the 100 shares at the market price.
Doesn't it seem too good to be true? You end up with either free money or buying the stock at a discount. Well, there are some risks involved, of course.
There are two significant risks in implementing this options strategy. These situations occur if the stock shoots up or comes way down. No matter how high the stock price goes up, the initial profits are limited to just the premium received. So the upside potential is very much limited in that sense. One way to combat this is to make sure that you will be receiving a high enough premium to still be satisfied if the stock soars before you purchase it.
The second risk is the situation if the stock plummets. Reversing your position (i.e., buying back the option) is one possibility but an expensive one at that. Your only other choice is to follow through with your obligation: you purchase the stock at a premium to the current market price. This loss can be offset by the fact that you were bullish on the stock for the long run and you picked a price that you were comfortable paying for the stock. If your intuition was correct than it's only a matter of time before the stock rebounds to the price you paid or beyond. But if something awful like accounting irregularities are announced, you might incur significant losses.
This strategy is ideal for volatile stocks that you are interested in holding for 5 or more years. They pay higher premiums because of their volatility, and having a long-term horizon will minimize your risks. Companies like Yahoo, E-Bay, AOL, EMC, Intel and Oracle would be ideal for writing puts on.
Finally, please note that this strategy is not for everyone, and does not guarantee anything. Speak with your broker to learn more about writing puts and especially to learn if this strategy would fit with your investment goals.
Previous article is Strategy: Buying on Margin
Next article is Strategy: Socially Responsible Investing
Category is Strategy|
Index of all articles