Assumer ZYX is a stock which an investor would like to own. Currently, it trades at $47.20, but the investor feels it would be a good buy only at $45 and that the stock could reach that level within the next two months. The investor can either place a limit order to buy ZYX at $45 or place an order to sell ZYX with a $45 strike price. By selling the puts with a $45 strike price, it must be remembered that the investor will have the obligation to buy the stock at $45 should the owner of the option exercise the right to sell ZYX. The investor would sell one put for every 100 shares of stock he is willing to purchase. A comparison of these two strategies will illustrate the differences between the two.
commissions and taxes have not been taken into account. These should be considered on a transactional basis, since they will have an effect on each transactional return.
Example: Placing an open limit order to buy 500 ZYX at $45 vs. selling 5 ZYX 2-month $45 puts at $1.25 when the stock is trading at $47.20.
Three possible scenarios at expiration are discussed below. At expiration, the stock will either be above $45, in which case the investor will not buy the stock, or below $45, in which case the investor can expect to buy the stock at $45.
Scenario 1: ZYX remains above $45 between the present and expiration – option not assigned.
Limit Order to Buy 500 ZYX @ $45
- No stock is bought
- Limit order still open
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Sell 5 ZYX 2-Month $45 Puts $1.25
- No stock is bought
- Keep premium of $1.25 x 5 contracts = $625
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By selling a cash-secured put or entering a limit order to purchase the stock, the investor will not be able to participate in a rise in the price of the underlying stock. If the puts expired without being assigned, the investor could sell another 5 puts if he was still interested in purchasing 500 shares of ZYX.
Scenario 2: ZYX is below $45 at expiration – option assigned.
Limit Order to Buy 500 ZYX @ $45
- Own (long) 500 shares ZYX @ $45
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Sell 5 ZYX 2-Month $45 Puts $1.25
- Own (long) 500 shares ZYX @ $45
- Less premium for put $1.25
- Net Cost = $43.75
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Using a limit order to buy ZYX, the breakeven would be what was paid for the stock. Selling the put reduces the breakeven to (ie the strike price less the premium of $45 - $1.25) $43.75.
Having sold the puts with a $45 strike price, should ZYX decline considerably, the investor still has the obligation to buy the stock at $45. This is a significant risk associated with writing cash-secured puts. However, the investor will have a cost reduction of the $1.25 premium. If a limit order had been used to purchase the stock at $45, then the investor would begin loosing money as soon as ZYX dropped below $45.
Scenario 3: ZYX is at $45 at expiration
The investor may face the outcome in either Scenario 1 or 2. With a limit order at $45, the investor may or may not buy the stock. There is no guarantee that the investor will buy ZYX at $45 until it trades below the investor’s limit price. If puts were sold, the investors has the obligation to buy 500 shares of ZYX, and therefore the investor may be assigned (have the stock ‘put to the investor’) or the puts may expire worthless. Either way, the investor will retain the premium.
Example: Placing a limit buy order on 500 ZYX at $60 vs. selling 5 ZYX 2-month $65 puts at $5.60 when the stock is trading at $65.
There is another way to use the cash-secured put. In this example, assumer ZYX is trading at $65. Again, assume the investor would like to own ZYX, but not at this level. The investor believes that ZYX would be a good buy at $60. The previous example showed the sale of an out-of –the-money put (ie a situation when the put strike price is below the current stock price) which required the price of the stock dropping to the strike price of the put before the stock would be purchased. An alternative approach is to sell an at-the-money put (that is, a situation when the put strike price and the current stock price are equal) or an in-the-money put (a situation when the put strike price is above the current stock price) in which the premium from the put assures a target net purchase price for the stock. By selling an in-the-money put, it is more likely that the put will be assigned and the stock will be purchased. The owner of an in-the-money put is likely to exercise the right to sell the stock above its current value, in which case the seller of the put (the investor) will be obligated to buy the stock.
Comparing the limit order to the at-the-money put sale shows the difference between each. Four possible scenarios at expiration will be discussed.
Scenario 1: ZYX rises above $65 between the present and expiration, and there is no assignment.
Limit Order to Buy 500 ZYX @ $60
- No stock is bought
- Limit order still open
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Sell 5 ZYX 2-Month $65 Puts $5.60
- No stock bought
- Keep premium of $5.60 x 5 contracts = $2,800
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Scenario 2: ZYX drops below $65, but remains above $60 by expiration – option assigned.
Limit Order to Buy 500 ZYX @ $60
- No stock is bought
- Limit order still open
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Sell 5 ZYX 2-Month $65 Puts $5.60
- Own (long) 500 shares ZYX @ $65
- Less premium for put $5.60
- Net cost = $59.40
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Selling the cash-secured put at a strike price of $65 for $5.60 enables the investor to buy ZYX below the $60 limit at a net cost of $59.40, even though ZYX never traded at that price. If the investor had used a buy order at $60, the investor would not purchase any ZYX stock.
Scenario 3: ZYX drops below $60 by expiration – option assigned.
Limit Order to Buy 500 ZYX @ $60
- Own (long) 500 shares @ $60
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Sell 5 ZYX 2-Month $65 Puts $5.60
- Own (long) 500 shares ZYX @ $65
- Less premium for put $5.60
- Net cost = $59.40
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Even if ZYX falls through the $60 limit, the cash-secured puts will have provided some downside protection. Since the net cost is $59.30, so is the breakeven. Had the ZYX stock been purchased with a limit order at $60, the investor would not have any downside protection, and would begin to loose money as soon as it dropped below the limit order cost.
Scenario 4: ZYX at $60 expiration.
If a limit order was used to buy the stock, the investor may or may not purchase it. However, had the put been sold, the investor might be put the stock and therefore own ZYX stock at a price of $59.40 (ie $65 strike price minus the $5.60 premium).
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