1. Option Basics 1.1 Introduction

An investor who sells a put believes that the underlying stock price will rise and that they will be able to profit from a rise in the stock price by selling puts. An investor who sells a put is obligated to purchase the underlying stock if the buyer decides to exercise the option. An investor who sells a put may also be selling the put as a way to acquire the underlying security at a cheaper price. If the stock is put to the investor, the investorâ€™s purchase price is reduced by the amount of the premium received. When looking to establish a position the seller must determine:

• Their Maximum Gain
• Their Maximum Loss
• Their Breakeven

Maximum Gain Short Puts

For an investor who has sold uncovered or naked puts, maximum gain is always limited to the amount of the premium they received when they sold the puts.

Maximum Loss Short Puts

An investor who has sold a put believes that the stock price will rise. There is, however, a limit to how far a stock price may decline. A stock price may never fall below zero. As a result, the investor who believes that the stock price will rise has a limited maximum loss. The worst thing that can happen for an investor who is short a put is that the stock goes to zero and they are forced to purchase it at the strike price from the owner of the put. To determine the maximum loss for the seller of a put use the following formula:

Maximum Loss = Strike Price â€“ Premium

Determining The Breakeven for Short Puts

Whenever an investor has sold a put, they believe that the stock price will rise. If the stock price begins to fall, the investor becomes subject to loss. In order for the investor to breakeven on the transaction, the stock price may fall by the amount of the premium they received for the option. At expiration the investor will breakeven at the following point:

Breakeven = Strike Price â€“ Premium

Example:

An investor has established the following option position: Short 1 XYZ May 30 put at 4

The Investorâ€™s maximum gain, maximum loss, and breakeven will be:

Maximum Loss \$26 or \$2,600 for the whole position (Strike Price â€“ Premium) Breakeven = \$26 = 30-4 (Strike Price - Premium)

If at expiration XYZ is at exactly \$26 per share and the investor closes out the position with a closing purchase or has the option exercised against them, they will breakeven, excluding transactions costs.

Notice the relationship between the buyer and the seller:

Because an option is a two-party contract, the buyerâ€™s maximum gain is the sellerâ€™s maximum loss and the buyerâ€™s maximum loss is the sellerâ€™s maximum gain. Both the buyer and the seller will breakeven at the same point.

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