Risk & Return When Selling Puts
The dominant consideration that a sold puts strategy hinges on is the consequence of being obligated to purchase the underlying stock after being exercised.
Ideally this writing strategy will be used when the greater probability is that the market is expected to stagnate and undergo a small retracement. In this event, the underlying will soften and enable a lower entry price for the buyer. The sold puts can be closed out in receipt of time decay, or may expire worthless. The premium received will offset the purchase price and so reducing risk, will find the strategy to be even more rewarding.
This risk averse strategy finds its motivation in the desire to own the stock initially, and so the worst result is that the stock is purchased at a higher price, and the writer of the put, loathed as they will be, will need to accept the full premium of the option to offset against the purchase price.
The more flamboyant participant may not intend to purchase the stock, but merely use the writing of put options to affect a bullish view of the market.
This of course will be a splendid result if that is indeed the case however; if this is incorrect it will find the writer at the risk of being put the stock which may be at a considerable premium to the market price prevailing at the time. This will occur after the writer has been exercised, and the fact of the premium received will be of little consolation.
American style options can be exercised at any time. Of course this is a privilege enjoyed by the buyer, the cost of which is defrayed through the pricing model. Rarely does life imitate art in the financial markets however, and so the risk of being put the stock needs to be investigated prior to executing this type of strategy.
The holder of both stock and puts effectively owns synthetic call options, and often the risk of being obliged to purchase the stock by investors who have purchased puts will come from internal forces such as dividend issues, with the most likely time a writer will be exercised being ex-dividend. When a stock holder has received the dividend, and the interest earned on sale proceeds from early exercise is greater than the cost of purchasing the corresponding call, in all probability the put is likely to be exercised.
Taking into account dividend declarations and issues, if the cost of the corresponding call option is less than the interest expense incurred in purchasing the stock, the risk of being exercised is greater than the annualized return for writing the put, and the strategy will be unsound. If forced to purchase the stock, it may well result in a fruitless adventure as the capital loss on a falling stock will far outweigh any premium received in an effort to outperform market performance indicators.
Ideally the benefit of low volatility in the market will support this strategy by way of time decay accruing to the writer who is obligated to purchase stock at an approximate market price. Of course, if uncertainty in the underlying exists, historical volatility can hardly be expected to remain low and the risk increases significantly.
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