Construction: Short 100 shares of stock, sell one put. By selling the put, you’ll receive immediate cash but have the potential obligation to buy shares for the strike price. Because you must eventually buy back the shares to close out the short position, the sale of the put creates an obligation you must eventually face.
Function: To enhance profitability of short stock position and to provide limited protection against adverse rising stock prices.
Bias: Neutral to slightly bearish.
When to Use: When you feel the stock will trade slightly down or in a tight range for a period of time.
Breakeven: Your breakeven point is the short stock price plus the put premium received. The premium received acts as a cushion against rising stock prices.
Maximum Gain: The maximum gain is limited to the premium received from selling the put plus any capital gains if you sell an out-of-the-money put.
Maximum Loss: You’ll incur losses for all stock prices above the breakeven point (stock price plus the premium). Because there’s no limit on how high a stock’s price can rise, the strategy has unlimited upside risk.
Key Concepts: If the stock trades down aggressively, your profits are limited by the put’s strike price. If the stock price falls below the put strike, you’ll incur a lost opportunity. For all stock prices above the breakeven point, you’ll head into unlimited losses. The Sell-Write strategy is philosophically identical to the Buy-Write strategy (Covered Call), which works the same way but in the opposite direction.
Example: Short 100 shares of stock at $50, and sell one $50 put for $2. Your effective selling price is increased to $52, which is also your breakeven point. If the stock price rises above $52, you’ll incur losses with no upper limit. If the stock price falls, you can only make the $2 received from selling the put. (If you sold a lower strike put, you’ll receive less money but can also make a capital gain in addition to the put’s premium.) If the stock price is below the strike at expiration, you won’t participate in any further gains. Instead, you’ll have to buy shares for the $50 strike price ($5,000), which closes out the position leaving you with your maximum $2 gain. However, you can also choose to roll the put option to another date, and receive additional option premiums, which further increases your short sale price. If the stock price stagnates, your investment continues to grow because of the option premiums collected.