Put and Call Writing Explained

by Jim Woods | December 3, 2010 5:16 am

Making money in any type of market can be an extremely trying proposition. You’ve got to pick the right stock, pick the right options — oh, and you’re timing also has to be right.

Considering how many components are involved with a successful trade, i.e., how many things you have to get right, why not take greater control of the variables by writing your own ticket?

Writing your own ticket involves writing put and call options. And though the goal of put writing versus call writing is different in a strategic sense, the ultimate goal of increasing your overall gains — along with your overall wealth — is one and the same.

Let’s take a look at how we can make money writing puts, and then we’ll take a look at how to do the same by writing calls.

‘Put’-tin on the Ritz: Writing Put Options

You often hear about a public company making the move to repurchase a block of its own shares on the open market. This is good for shareholders because it reduces the number of shares outstanding, while typically boosting the value of existing shares. It also increases a company’s earnings per share.

When PC moguls Bill Gates and Michael Dell wanted to do a share-buyback program for their respective empires, they took advantage of the options markets to increase the return on their investment. What they did was write (or sell) put options, and by doing so they created a win-win situation with their stock performance.

How was this accomplished?

Well, when put contracts are written, if the stock goes down in value then the shares are “put” to the writer (i.e., to buy from the owner of the shares). But if the market price spikes, as the person who has shorted the puts, you get to keep the premium you collected when you initiated the position (as “selling to open” an options position oftentimes results in an initial credit to your trading account).

Either way, it’s better for the shareholders of a company participating in a buyback because it ultimately means that the company is purchasing its stock back at lower prices, thus increasing the return on the investment for the company and, in turn, its shareholders.

Of course, writing puts isn’t just for the big guys. Individual traders can use this technique to enter into a long stock position.

Just keep in mind that when you’re selling a put option, you don’t expect the stock price to drop below the exercise (or strike) price, nor to increase significantly. That way, if the option owner assigns you to buy the stock, you will do so at the strike price of the option.

So if a stock is trading for $25 and you short a $22.50 put, if the share price dips to $22.50 and the option holder “puts” that stock to you, then they’ve saved you the legwork of making the purchase and you’re now the owner of the stock you were planning to buy anyway.

The ‘Call’ of the Wild: Writing Call Options

Often investors cite their fear of risk as the reason why they might shy away from trading options. And while the level of risk can increase with some of the more complicated options strategies out there, that’s not the case with writing covered calls.

In fact, writing covered calls[1] is one of the most frequently used and safest options strategies, because it is one of the most conservative plays a trader can make.

On the surface, writing covered calls seems like hitting a home run. Also known as a “buy-write,” this strategy involves selling call options against stock that you already hold long.

When you sell an option, you immediately collect a premium up front, and because options settle in one business day, the credit you collect hits your trading account a day later. It’s like you get to make money just because you decide to.

Suppose you’re sitting on 1,000 shares of the hypothetical XYZ Corp. with the stock currently trading at $34. Suppose the shares are trading pretty steadily and haven’t made a significant jump in a while.

Instead of waiting around and hoping for the stock to receive its own version of a stimulus package, you can take the opportunity to sell calls at the $35 strike against your position.

Let’s say the XYZ Oct 35 Calls trade at $1.95 per share. That’s $195 per contract, and as one contract covers 100 shares, you can sell a 10-lot, or 10 contracts, for $1,950, so that’s the amount of money that you would take in by selling your calls.

Why the XYZ Oct 35 Calls? Well, for two reasons.

One, the strike price is higher than the current market value, which means that you are agreeing to sell your shares for $35 each should the buyer wish to exercise his or her right to buy the stock (i.e., call it away from you). This means that in addition to the $1,950 that you took in, you’d be selling the shares for $1 more than the level where they’re currently trading.

Two, insofar as choosing the October calls, their expiration date is far enough away that if you are expecting the stock to move up (so that the options become more valuable), you’re giving yourself enough time to be right.

But what if the stock doesn’t go up to, or through, that $35 strike by that third Friday in October?

Well, then you’d keep your premium money — as well as your stock — because the option buyer wouldn’t want to call the shares away from you at a cost that’s above the market price. His or her option would likely expire worthless.

Owning stock and selling covered calls against it is like having an apartment building and collecting rent on the available units. If you can’t find tenants or just haven’t gotten around to renovating a perfectly usable space, then you’re not making any money. And in neutral markets, not collecting “rent” with options trading means you could be passing up a lot of gains that you might never see by just holding on to the stock and playing the waiting game.

Endnotes:
  1. writing covered calls: http://www.optionszone.com/trading-ideas/gallery/writing-covered-calls.html

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