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Taking on Risk and Hoping It Doesn’t Backfire

Oh boy. There’s something new to be filed under the category of, “Well, it seemed like a good idea at the time.” It is cash secured puts on the S&P 500. According to The Wall Street Journal, pension funds in Hawaii and South Carolina are using the strategy to generate income. It is a strategy that works until the market incurs a sizeable drop. At that point, the feeling of regret will loom and the bottle of aspirin will be opened.

For those you not familiar with option strategies, a put option gives its owner the ability to sell an asset at a specified price within a certain period of time. A put contract on a stock with, say, a strike price of $50 and an expiration of December 2016 will allow the put’s owner to sell the stock at any point between now and the close of trading on December 16. (From a practical standpoint, options contracts on stocks expire on the third Friday of a calendar month). If the stock stays above $50 between now and mid-December, the contract will expire worthless since there is no reason for the put holder to exercise the contract when the stock can be sold on the open market at a higher price. If the stock were to fall to any price below $50 (e.g., $40), the owner of the put can sell the stock for $50.

One of the key things about options is that they are binding contracts. When an option is written, the writer is obligated to honor it. Furthermore, the writer of the contract has no control over when or if the contract will be exercised. The investor who purchases the contract has the sole right to exercise it. The put writer must buy the stock at the price specified in the contract (the “strike price”) no matter what the stock’s prevailing market price is. So, if a put has a strike price of $50 and the stock falls to $35, the writer of the put can be forced to buy the stock at a price of $50 per share. (It’s the opposite for a call strategy. The buyer of a call option can force the call writer to sell the stock at a below-market price.)

Writing options is profitable as long as they are not exercised. If the contract expires worthless, the option contract writer gets to keep the price of the contract (the premium), assuming this investor has not closed out the position beforehand. Should the contract come into the money—meaning it makes mathematical sense for the option buyer to exercise the contract—the buyer benefits. It is here where writing options can backfire, and the type of option written matters.

If an investor holds a stock and writes call options (a strategy referred to as covered calls), the investor gives up potential upside if the option is called. Assuming the investor wrote the contracts with a strike price above what the stock cost to acquire, a profit is made, though a smaller profit than could have been made if the contract hadn’t been written.

Conversely, all of the stock’s potential downside is taken on by the investor writing the put. Assuming the investor wrote the contracts with a strike price below what the stock cost to acquire, a profit can only be made if the premiums received and the proceeds from selling the stock exceed the loss incurred from being forced to buy the stock at a price below the put’s strike price. The fact that cash was set aside to cover the put in the event of the contract being exercised—as is the case with a cash-secured put strategy—does not change this outcome. A put writer’s only out in instances when the underlying asset falls below the strike price is to buy an offsetting call option and hope that the purchase price of the call option does not significantly exceed the proceeds received for the put option.

In blunt terms, writing puts is taking on risk and hoping the strategy doesn’t backfire.