Option Call Risks

Comparisons between selling calls and selling puts provide good insights about risk. Stock selection contains specific risks for call sellers. More attractive option premiums are associated with more volatile stocks. So covered call writers may be prone to selecting higher-risk stocks in order to sell higher-than-average time value.

The same risks apply to put sellers. Higher time value premiums for puts are going to be found on stocks with higher-than-average volatility. The direction of price movement you desire is different with puts than with calls, but the risks in the underlying stock are the same.
Put sellers face the risk that the underlying stock's market value will fall. The more drastic the price falls, the greater the risk of exercise. However, a put seller's perception of risk has to be different from that of the call seller. The key to selecting puts should not be the size of the premium, but your willingness to buy the stock at the striking price in the event of exercise. Depending solely on premium dollar value can be deceiving as well. For example, a put premium of 4 on a $30 stock with a striking price of 30 provides four points of downside protection and, in the event of exercise, a return of 13.3 percent. A premium of 8 -- twice as much -- on a $90 stock with a striking price of 90 represents a return if the put is exercised of 8.9 percent. Exercise in the first example would require you to purchase stock at $30, and in the second example you would be required to invest $90 per share. So your exercise cost would be three times higher ($9,000 versus $3,000) but your if-exercised rate of return would be about two-thirds as good. This demonstrates that depending solely on premium levels can be very deceiving. A more realistic evaluation of risk is required to make a logical decision.

However, selling puts does require planning and risk evaluation in the same manner as selling calls. For example, the margin requirement a brokerage firm imposes as a hard-and-fast rule means you have to plan ahead and have equity on hand before you begin selling puts. This naturally limits the transaction volume, since no one has unlimited equity in their portfolio.

Smart Investor Tip

Whenever you sell puts, your brokerage firm is going to require that you have at least 50 percent of the exercise price left on deposit. In this way, in the case of exercise, your margin requirement will be met.

The evaluation of risk for put sellers is different than for call selling. The put seller needs to apply those fundamental and technical tests to a stock in the same way as call sellers. The difference, however, is that while covered call writers own shares of the stock when they sell a call, the put writer has to be willing to buy the stock if exercise does occur. Your risk is limited to the degree of short position risk you can assume at one time and, of course, the risk exposure your brokerage firm will allow you to carry. You will need to be able to demonstrate that you have equity available to pay for shares in the event of exercise. A short position always carries a degree of risk, and if the market trend turns downward, your short puts could be exercised within a short period of time.

Given the possibility of gaining shares at or slightly below current market value, why bother to sell puts at all? In the examples in the previous section, the net result of selling a put was acquisition of stock at a net cost of $49 when market value was $48. Remember, however, that exercise is only one possible result. The put seller should be happy to acquire the stock for an adjusted basis of $49, given what the analysis of the company revealed. A value analysis should indicate that $49 per share is a good bargain. At the same time, put sellers will also profit if the stock rises. As this occurs, puts lose value and will expire worthless or can be closed at a profit. So rather than simply buying shares (placing more capital at risk), the put seller has a two-part strategy. If exercised, the net cost is considered a fair value, in spite of potentially lower current market value. And if the put falls in value as a result of rising market value in the stock, then the put sale is profitable. As a form of leverage, put selling produces profits from market movement without the requirement of investing in 100 shares of the stock.
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2020. Content published with author's permission.

Posted in ...