Either PUTs or CALLs can be written naked, that is without stock as security. In both cases, the object of the strategy is to collect the option premium without ever having to buy the underlying stock. Selling PUTs is the more common of the two approaches. PUTs are written when the market is expected to go up. And the market generally rises more than it goes down. CALLs are written when the market is expected to decline. Writing a PUT is sometimes used as a means of acquiring the underlying stock for less money. The PUT writer not only collects a premium for selling the PUT, but also has the possibility that the stock will be PUT to them at a lower stock price (at the strike price). Although the objective was to collect the premium without having the stock PUT to them, it may be desirable to buy the stock if it is low enough in price and considered a very sound stock holding for a long term investment. CALL writing uses the opposite strategy from writing PUTS. The following discussion will concentrate on the PUT writer, which is the more popular technique.
The obligation required of the PUT writer is to purchase the number of shares contracted, of the underlying stock, at the strike price, at any time during the life of the contract. As long as the underlying stock price remains at or above the strike price the option will not be exercised and the underlying stock need not be purchased. The PUT writer wants the underlying stock price to rise. Therefore, the stock does not have to be purchased and the premium can be kept, otherwise the stock is a desirable purchase at this price and will be purchased if it declines (drops under the strike price).
Generally, the stocks selected, for selling PUTs, should be fundamentally sound and poised for growth. Ideally the stock should be about to rise in value based on its chart pattern, fundamentals, analysts recommendations or industry trends. Other than conditions specific to the stock, the market should be in an up trend and conditions favorable for a rising market. This is a bullish strategy.
The PUT writers obligation is the strike price of the stock. It is the price that the stock must be purchased at in case the investors timing judgement is wrong. The strike price obligation is slightly offset by the premium originally received. Upon selling the option, this premium is deposited into the investors account. A writer of PUTs should have the cash equivalent of the strike price in reserve, if it should be needed for the purchase. All of the above discussion is without consideration of margin. Each brokerage firm may have different requirements on the cash needed for security. The use of margin will increases the risk / reward of each trade.
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