Okay, here we go. A stock is at $13.50. You really like the company. You think this stock could easily go to $18 or $20. You think this because:
1. The stock is rolling between $13 and $20, and has done so frequently. You know this from looking at its chart.
2. You have heard good news from the company— i.e., new products, expansion, great earnings, et cetera.
You could buy the stock or buy the $12.50, $15 or even $17.50 call options. If the stock rises as expected, the value of your investments increases. Both of these choices require an expenditure of money. If you buy the stock on margin, you only have to put up a percentage of the money (in most cases 50%). I bring this up here because margin requirements will be necessary when selling puts—see the section on “cash requirements.”
Let’s not buy the stock or call options. Let’s sell a $15 put, or even the $12.50 put, if you think the stock may go down further. What does this mean? Let’s use the $15 put example first. If you sell a $15 put, you are literally committing yourself to buy the stock at $15. You no longer have just the right (as in buying an option), you now have the obligation to perform, if the stock gets “put to you.”
You see, by writing a put (selling), you have given someone the right to sell you the stock at $15. They don’t know who you are—all they have done is purchase a put option—giving them the right, not the obligation, to sell the stock to someone at $15. When would they do this? When the stock is below $15. Now, if the stock is at $14.75 or $14,875 on the expiration date, it’s iffy whether or not it will get put to you. (See “Selling Calls” in the Wall Street Money Machine for more information on the execution of these close orders.) However, if the stock is at $14 or $13 it will get put to you at $15.
What did you get for selling the put? And when will you get the cash? The premium you receive is determined by how far the strike price is in the money or out of the money, and how long until it expires.
