 probability  of  earning  a  profit,  but  thisstrategy does not guarantee a winning result on every trade. The situationis the same as when you write covered call options: If option buyers didn’tearn a profit at least some of the time, there would be no buyers of put op-tions when you want to write them.
When expiration day arrives, if the stock price is above the strike price,then the put option expires worthless and you are under no further obliga-tion to buy stock. Your profit is the cash you received when writing the op-tion. If the price of the stock is below the strike price, you are assigned anexercise notice and must fulfill the obligations of the contract—namely youmust buy the stock at the strike price. This is something you were willing todo  when  writing  the  option,  so  it  should  not  be  considered  an  unhappyevent.
When you are assigned, you have several alternatives in terms of whatto do next. You can write covered call options against the stock (recom-mended), hold the stock without writing call options (hoping it goes up in
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price (this is against the teachings of modern portfolio theory), or sell thestock.
What  do  you  get  in  exchange  for  accepting  both  a  limited  potentialprofit and the obligation to buy stock at the strike price? You are paid acash premium to accept that obligation. You receive this money up front,and it’s yours to keep, regardless of whether the other party ever forces youto buy stock.
When writing covered calls, you must spend cash to buy stock. Whenyou write uncovered puts, cash is kept in reserve in case you are requiredto  buy  stock  later.  When  interest  rates  are  high,  that  reserve  cash  earnsenough  interest  to  boost  your  annual  profits.  This  is  not  important  intoday’s interest rate environment, but is something to keep in mind.
Questions
Three  questions  always  arise  in  the  minds  of  those  who  are  consideringadopting uncovered put writing.
1. Isn’t it foolish to accept the option premium in exchange for accepting
the risk that the stock might undergo a severe price decline?
2. If I’m bullish, wouldn’t I be better off trying to buy stocks that can pro-
vide much larger returns on my investment?
3. If  my  goal  is  to  accumulate  wealth  over  the  years,  is  this  a  winning
strategy?
Answers
For most investors, the answers are no, no, and yes.
1. When you buy stock, you take the same risk. If the stock undergoes arapid price decline, you suffer a substantial loss. But the put writer isbetter  off  than  the  investor  who  simply  buys  stock.  Sure,  they  bothlose, but the put writer keeps the put premium to reduce (and some-times even eliminate) the loss.
2. If you have the ability to find those stocks, more power to you. The ev-idence  suggests  neither  public  investors  nor  professionals  have  thatability on a consistent basis. Writing uncovered put options enhancesyour investment returns and gives you an excellent chance of beatingthe averages most of the time.1
3. This strategy can produce consistent market-beating returns. Allowingthose earnings to compound over time is an excellent path to accumu-lated wealth.
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GOALS OF WRITING UNCOVERED PUT OPTIONS
There are two major objectives for uncovered put writers: You either earna  profit  (keep  the  option  premium)  or  you  buy  your  stock  (or  exchangetraded fund [ETF]) at a favorable price.
When you write a naked put option, there are only two possible results
when expiration day arrives.
1. If the stock or ETF is higher than the strike price, the put option ex-pires worthless, and your profit is the cash you received for writing theput option.
2. If the stock or ETF is below the strike price, you are assigned an exer-cise notice and buy shares of stock at a predetermined price. That priceis the strike price reduced by the amount of the option premium. Forexample, if you write an ETFQ Nov 40 put for $1.50 and are assigned onthat put option, you pay a net of $38.50 for each ETFQ share.
Investors who should consider writing uncovered put options fall into
two categories:
1. Investors  who  want  to  buy  the  underlying  asset  (stock  or  ETF)  at  aprice below the current market price. Those investors have a furtherchoice:
a. Wait and hope the stock declines to the desired level, so it can be
bought.
b. Write a put option. You either buy the stock at your price or earn aprofit as a consolation prize. That prize is the option premium.2. Investors  who  want  to  earn  a  profit  if  the  stock  (or  ETF)  either  in-creases in price or remains relatively unchanged in price. That profit isrepresented by the option premium.
Thus, this strategy may be appropriate for you when you want to buyshares of stock but are unwilling to pay the current market price. It’s alsoappropriate for investors who want to earn a profit if they are unable to buystock at their target price. Investors who place bids below the market, hop-ing to acquire shares at a later date and at a lower price, do not earn anyprofit if the stock does not decline to a price level they are willing to pay.When the put writer fails to purchase stock because it does not decline toan  acceptable  price  level,  a  consolation  profit  is  earned.  That’s  surely  a better result than having a bid go unfilled. Imagine—this is equivalent to
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earning  a  profit  just  because  you  entered  a  bid  to  buy  shares  at  a  pricebelow the market.
Writing  a  put  option  may  obligate  you  to  purchase  shares  at  a  laterdate, so be certain you have the cash available in the event you are forcedto buy stock.
NAKED PUT WRITING IN ACTION
Choosing Which Put to Sell
Let’s look at an example. ABCD is a volatile stock you have been interestedin buying for some time. Your target buy price is somewhere in the low $14sand it’s currently trading near $15.50. Because it’s a volatile stock, the op-tion premiums are attractive for writing.2 When you check current optionprices online, you note there are several options you can write that enableyou to meet your investment objective. Let’s look at several possibilitiesand consider the benefits and disadvantages associated with each in an ef-fort to select which put option to sell. Note that different investors makedifferent choices, and none is making a mistake.
Assume it is currently the first week of August and expiration is three
weeks in the future.
• ABCD Aug 15 put is $0.60 bid.• ABCD Sep 15 put is $1.25 bid.• ABCD Sep 121⁄2 put is $0.30 bid.
If you write the Aug 15 put, you receive $60 per put option. If the put ex-pires worthless, your profit is $60 for a three-week investment. Assumingyour uncovered put positions are always cash backed, you must maintain$1,500 in the account for each put sold. Because you can use the cash gen-erated from the sale of the put, your investment is $1,440 (plus commis-sions). The $60 profit represents a return of 4.16 percent (over 70 percentannualized) (4.16 percent return for three weeks is [4.16 × 52] ÷ 3, or 72.22percent).
If the stock declines in price and eventually you are assigned an exer-cise notice, then you own the stock at $14.40 per share. If that is an accept-able  purchase  price,  then  writing  the  Aug  15  put  is  a  good  investmentchoice for you. Investors who demand an even lower purchase price canconsider writing a put option with additional time premium.
If you decide to write the Sep 15 put, you receive $125 per option. Thistime there are seven weeks before expiration day. When expiration day ar-rives, there are two attractive possibilities:
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1. You earn a seven-week profit of $125, or a return of 9.09 percent (67
percent annualized).
2. You own the shares, at $13.75 per share. (You pay 15 and deduct the op-
tion premium of 1.25.)
Of course, there is no guarantee of earning a profit, and it’s possibleABCD stock will be trading considerably below $13.75 per share when youare assigned an exercise notice and forced to purchase the shares. Lookingat the stock from today’s perspective, and knowing the outcome is either aprofit of $125 or a reduced purchase price ($13.75), writing the ABCD Sep15 put option is an excellent investment choice.
There is one other alternative to consider. If your main goal is to earna profit and you are less inclined to become an owner of ABCD shares, writ-ing the Sep 121⁄2 put option may appeal to you. You collect a significantlylower option premium, but, in return, it’s far more likely that the option ex-pires worthless and you do not become a shareholder. Writing this put canproduce  either  of  two  outcomes  when  expiration  day  arrives  in  sevenweeks:
1. The  option  expires  worthless  and  you  earn  $30  on  an  investment  of$1,220.  That  represents  a  return  of  2.46  percent  (18  percent  annual-ized). This provides a lower return than writing the Sep 15 put, but it ismuch more likely you will earn that return.
2. You own the shares, paying $12.20. If you were eyeing the shares at aprice in the low $14s, then this must be an acceptable purchase price.
If  expiration  day  finds  you  owning  the  shares  because  you  were  as-signed an exercise notice on puts you sold, you have the choice of holdingand hoping for a price increase (this choice goes against the teachings ofMPT) or writing covered call options (recommended) to earn additional in-come. The investment objective is eventually to be assigned an exercise no-tice by the owner of a covered call option you write. When that happens,you should have a good profit, as represented by the put and call optionpremium(s)  you  collected  while  waiting  to  sell  the  stock.3 Here’s  how  itworks:
1. You write an ABCD Sep 121⁄2 put and collect a premium of $0.30.2. At expiration, you are assigned an exercise notice. You now own ABCD
stock at a cost of $12.20.
3. You write an Oct 121⁄2 call and collect a premium of $0.25, reducing the
cost of your ABCD shares to $11.95.
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4. When  October  expiration  arrives,  assume  ABCD  is  below  the  strike
price and the call option expires worthless. 
5. You  write  a  Nov  121⁄2 call  option  and  collect  a  premium  of  $0.30,  re-
ducing the cost of your ABCD shares to $11.65.
6. Finally, good news. The stock rallies and when November expirationarrives you are assigned an exercise notice on the call option and sellyour stock at the strike price.
7. You sold ABCD at $12.50 and bought at a net cost of $11.65. You arewhere you wanted to be when you started: You have a profit and ownno  shares  of  ABCD.  The  profit  is  $0.85  on  an  original  investment  of$1,220, or 7.0 percent in three months.
Choosing the Expiration Month
As with writing covered call options, selling near-term options allows youthe opportunity to earn the highest annualized profits. Writing options withmore time remaining allows you to collect higher premiums, providing youwith a lower break-even price if you are assigned and must buy stock. Yourtarget price for buying the shares (if assigned) helps determine the properexpiration month to choose. There are two ways you can get a lower pur-chase  price  for  the  stock  (if  assigned):  Write  an  option  with  either  addi-tional  time  before  expiration  or  a  lower  strike  price.  By  practicing  withpretend trades (“paper trading”), you can gain a good feel for how these un-covered put positions perform in the real world. As you become comfort-able with the process, you soon gain the confidence to choose the specificput option that best suits your needs.
When option premiums are low, as they are in today’s market (com-pared to average prices dating back to 1988), writing options with shorterexpirations is desirable so you can boost your potential annualized returns.When  option  premiums  are  higher,  as  surely  they  will  be  again  one  day,writing options with more time to expiration provides the comfort of addi-tional safety and lower break-even points. As with all aspects of optionstrading, each investor must adjust the strategy of writing naked put optionsto suit personal preferences.
Choosing a Put to Sell Summary
When you are eager to own the stock, choose a put that is more likely to bein the money when expiration day arrives. Thus, choose at-the-money orslightly in-the-money puts.
If your paramount consideration is the price at which you buy stock,then choose a put whose premium allows you to own the shares at your tar-
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get price (or lower). Of course, you may never buy the shares, but you keepthe put premium as your profit and consolation prize.
If your investment objective is to earn a profit and you are willing toown the shares (but would rather not), then choose an out-of-the-moneyput, as there is less chance you will be forced to buy stock when expirationday arrives. But don’t sell just any put—be certain there is enough time pre-mium in the option to allow you to earn a minimum return on your invest-ment. Each investor has to establish a minimum target, but the suggestionhere is that the minimum should not be less than 0.5 percent per month(after commissions). (Personally I currently aim for a minimum return of11⁄2 percent per month.)
RISK AND MARGIN CONSIDERATIONS
Writing uncovered put options is a very attractive strategy. One major reasonis risk. This investment method is slightly less risky than simply buying andholding stocks, and every investment advisor tells the world that owning a di-versified  portfolio  of  stocks  is  a  prudent  investment  choice.  As  an  addedbonus, the chances of earning a profit are increased (compared with buy andhold) when you write uncovered put options (or covered call options).
An investor who buys 1,000 shares of stock at $20 per share is investing$20,000. When you write 10 put options with a strike price of 20, you are ac-cepting the obligation to buy 1,000 shares of stock at $20 per share at a laterdate. You may never have to honor that obligation, but if you do, your riskbecomes the same as the investor who buys the shares now. But you havethe advantage of having sold 10 put options, and the cash you received low-ers the cost of your investment. Of course, your maximum profit is limitedto the cash you receive when writing the puts.
If  your  position  is  cash  backed—that  is,  if  you  have  $20,000  cash  inyour  account  in  case  you  are  called  on  to  honor  the  obligation  to  buystock—then you are in the same position as any other stockholder whenshare prices decline.
Warning
Sometimes  put  writers  make  careless  decisions  and  find  themselves  introuble. This occurs when investors sell too many put options. Investorswith $20,000 to invest know that $20,000 is the maximum possible loss (un-less they choose to trade on margin and borrow cash from their brokers).When buying stock, investors know how much cash to spend and do notbuy extra shares.
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However, put writers might erroneously think that it isn’t a big deal tosell 20 or 30 put options, instead of only 10. After all, they might mistakenlybelieve, “What’s the harm in selling an option that costs only $50 per con-tract? That’s a pretty small trade. If I can make $500 selling 10 puts, whydon’t I just sell 30 and make $1,500?” This mind-set must be avoided. Whenwriting put options, always think about what you are going to do if you areassigned an exercise notice. If you are assigned on 30 puts with a strikeprice of 20, you must purchase 3,000 shares at $20 for a net cash outlay of$60,000. If you don’t have sufficient cash in your account and cannot eithertransfer that cash into your account immediately or borrow it from yourbroker, you are going to receive a margin call.4 That’s an event you don’twant to happen and something that is easily avoided.
Advice: Don’t  overextend  yourself.  When  you  begin  your  put-writingstrategy, be certain you are fully cash backed. Later, when you have moreexperience, you can begin to use a small amount of margin. But the moremargin you use, the greater the risk. Please don’t be careless.
The  main  risk  with  adopting  a  strategy  of  writing  uncovered  put  op-tions for unwary investors is not the strategy itself, but their inability to rec-ognize that it is easy to sell too many put options. This cannot happen toyou if you are constantly aware of the cash you need, just in case you areassigned an exercise notice on each and every put option you sell. Such anassignment is unlikely before expiration day, but if you are aware, then youwill not sell too many put options.
It’s true that you can avoid being assigned an exercise notice if you re-purchase  any  options  you  sold  previously—before you  are  assigned.  Butsometimes an assignment notice arrives unexpectedly, and it’s too late torepurchase the puts once you receive the assignment notice. Each broker
The Importance of Being Earnestly Cash-Backed
Note: The  covered  call  writer  does  not  have  the  problem  of  writing  toomany covered calls because that strategy uses cash to buy stock. The cov-ered  call  writer  understands  the  necessity  of  not  opening  new  positionswhen out of money. It is less obvious when the uncovered put writer whouses  margin  is  out  of  money.  Thus,  it’s  important  to  keep  track  of  theamount of cash required, if you are assigned on all of the puts you sold.
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handles this sticky situation differently, so be certain you know what yourbroker does when you don’t have enough cash to cover an assignment.
Write uncovered puts. Collect those premiums. Buy stocks you want toown at favorable prices. But don’t sell more put options than your financialcondition allows. Be aware that each option you sell may obligate you topurchase 100 shares of stock, so always know how you will pay for thatstock if and when you receive an assignment notice. To repeat: The mainrisk of this strategy is writing too many put options and not knowing whatto do if assigned on each of the put options you sell.
One  further  risk  is  worth  considering  when  you  write  an  uncoveredput. It’s possible to miss out on a surge in the value of the shares you wantto buy, but an unlikely combination of events is required before this riskcomes into play.
• The stock drops in price to a point where you would have bought it.• The stock then rallies substantially beyond the strike price of the put
option.
If these events happen, then the investor who buys shares easily out-performs the investor who writes the uncovered put option. Although thisscenario  occasionally  occurs,  it  is  far  more  likely  that  the  put  writerachieves a better financial result than the investor who enters a low bid inan attempt to buy stock. After all, the put writer outperforms whenever theshares decline in price, remain relatively unchanged, or increase in value upto the break-even point (see box). This investment strategy is very similarto covered call writing in that it produces better results the vast majority ofthe time.
Break-Even Points for Put Writers
Break-even points for put writers are the same as those for call writers (seeChapter  9).  The  upside  break-even  point is  the  stock  price  at  which  youmake the same profit as the investor who is simply long stock. That pointequals the strike price plus the put premium. Above that price, the investorwho owns stock makes additional profits and the put writer does not.
The downside break-even point is the stock price below which sellingthe  put  option  is  no  longer  profitable.  That  price  equals  the  strike  priceminus the put premium.
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COMPARING RISK: COVERED CALLWRITING AND UNCOVERED PUT WRITING
As mentioned earlier, the risks associated with covered call writing and un-covered put writing are identical. When you adopt covered call writing, youbuy stock and collect the premium from writing a call option now. Whenyou adopt uncovered put writing, you agree to buy stock later (if called onto do so) and collect the premium from writing a put option now.
The data in Table 11.1 illustrates the cost and risks associated with ei-ther position. In our example, the stock is priced at $42 per share, and youwrite an option with a strike price of 40.
• An identical investment ($3,850) is required, either in cash for the cov-ered call or cash kept in reserve (so the put option is cash backed) forthe uncovered put.
• Maximum profit occurs when the stock is above the strike price (40)
when expiration arrives.
• Maximum profit equals the time premium of the option.• Maximum loss (stock goes bankrupt) is $3,850.
SUMMARY
Uncovered (naked) put writing is a bullish strategy for investors who wantto reduce the downside risk of owning stocks. When adopting this strategy,investors either collect a profit when the put expires worthless or buy theshares they want to own at a reduced price when assigned an exercise no-tice. Profits are limited to the premium collected when writing the option.Despite  opinions  to  the  contrary,  this  strategy  is  more  conservativethan that of simply owning stock and increases the chances of outperform-ing  the  market  over  an  extended  period  of  time.  Just  remember  not  tooverextend your resources.
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C H A P T E R   1 2
Historical Data
BuyWrite Index and Volatility Index
It’s one thing to read about an options strategy, but I’m sure you want to
know  if  the  strategy  really  performs  as  advertised.  Does  it  really  en-hance  returns  for  stock  market  investments?  Fortunately  evidence
shows it does.
BUYWRITE INDEX
The Chicago Board Options Exchange (CBOE) publishes data for BXM, orBuyWrite index, a benchmark designed to track the performance of a hy-pothetical covered call writing strategy. BXM is based on a portfolio thatapproximates ownership of each of the stocks in the S&P 500 index (SPX)and writing covered call options on the index. Data for this index are avail-able beginning in June 1988.
The  performance  of  the  BXM  is  based  on  the  following  five-step  in-vestment strategy. (Note: This description is presented to enable you to un-derstand  how  the  BXM  works;  this  investment  methodology  is  notrecommended for readers to follow.)
1. Buy and maintain ownership of a portfolio of stocks that mimics theS&P 500 index. An investor does not have to own the entire index, aslong as the stock portfolio has a very high correlation with that index.2. Write the near-term SPX call option early in the morning on the third
Friday of each month.1
111
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3. To  provide  a  constant  methodology,  the  call  that  is  sold  always  hasone  month  remaining  to  expiration.  The  strike  price  is  always  justabove  the  current  index  level  (the  first  call  option  that  is  out  of  themoney).
4. The call is held through expiration and is cash settled (see box) basedon prices at the opening of the market on the third Friday of the month.Note: The strategy used to calculate the BXM does not allow for any ad-justments. In the real world, the results of an investor who adopts thismethodology may differ from that of the official BXM if that investormakes an adjustment to the position. Chapters 15 and 16 provide ex-amples of how and why investors may want to make such adjustments.5. Every  month,  a  new  one-month  call  option  is  written,  based  on  theidentical  strategy.  Because  assignments  are  cash  settled,  an  investorwho adopts this strategy never has to worry about selling and repur-chasing  stocks,  except  for  making  an  occasional  change  in  portfoliomakeup (when the composition of the index changes). If the investor isassigned an exercise notice, no shares of stock change ownership.
Now that the BXM exists, an important question remains: What does it  tell  us  about  the  financial  results  of  adopting  a  covered  call  writing strategy? If writing covered calls is an advantageous strategy, would fol-lowing that strategy produce meaningful benefits in the real world? Theexistence  of  the  BXM  index  provides  information  needed  to  answer  thequestion.2
Cash-Settled Exercises and Assignments
Because SPX options are cash settled, the portfolio owner never has to re-linquish shares. When a cash-settled option expires in the money, the op-tion owner’s account is credited, and the option writer’s account is debited,the  proper  amount  of  cash.  The  cash  amount  is  equal  to  the  number  ofpoints by which the option is in the money, multiplied by 100.
For example, if the investor using the BXM strategy writes an SPX callwith a strike price of 1,110 and if the settlement price of the SPX (based onopening prices of each of the stocks on the third Friday of the month) is$1,117.35, then the writer of the call option must deliver cash to the ownerof the option. That cash amount is $1,117.35 – $1,110.0, or $7.35 × 100.That translates into $735 per contract.
If an option is out of the money at expiration, it simply expires worth-
less and no cash is transferred.
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It’s possible to compare investment returns when owing a diversifiedportfolio of stocks (index mutual funds) with returns using a covered callwriting strategy. Keep in mind that the BXM strategy has a slightly bullishbias, because the option written is always slightly out of the money. Indexmutual funds have a totally bullish bias, as they are fully invested in stocksand earn profits when stock prices increase and suffer losses when theydecrease. Figure 12.1 illustrates the comparison.
The figure clearly shows that the option-writing strategy easily outper-formed an investment plan of simply buying and owning stocks over this16-year period. It’s also noteworthy that this was a bullish period for themarket, with the S&P rising from the mid-260s in June 1988 to over 1,100 inmid-2004. As discussed in Chapter 10, covered call writing outperforms abuy-and-hold strategy through most stock market conditions, but comparesless well in strongly rising markets. Even though these 16 years were pri-marily  bullish,  covered  call  writing  significantly  enhanced  investors’  re-turns on investments.
Table 12.1 presents the year-by-year comparison of investment results.The  buy-write  strategy  enhanced  investment  returns  in  only  9  of  the  16
BuyWrite Index versus S&P 500 IndexJune 1, 1988–March 2004
ecnamro
freP
7.00
6.00
5.00
4.00
3.00
2.00
1.00
0.00
06/88
06/90
06/92
06/94
06/96
06/98
06/00
06/02
Date
FIGURE 12.1 BuyWrite Index versus S&P 500 Index June 1988–March 2004
Source: Chicago Board Options Exchange
SPX and BXM were set to a value of $1.00 as of June 1, 1988. Actual SPX was266.69. Upper line