Conversation with a misgudied options rookie

Today's post, is a follow-up to my earlier discussion with Larry.  My original thought was to reply to his comment/questions and let it go.

However, I consider this to be a good topic for a post because it shows how some people can grab onto bad information right from the beginning of their options education, and once off course, must be persuaded to stop what they are doing and try to re-learn what they already believe they know about options.

That's not so easy.  And it's even more difficult if they have been taking lessons and paying someone for all the bad information (I doubt that is what happened to Larry).

I truly sympathize and hope I can get him back to the beginning so that he can get it right this time.

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Mark,

Thanks for taking the time to answer my questions. Regarding puts, I need a little more clarification. Here is what I understand so far: Underlying stock price is $20. For a premium of $2, I buy an at-the-money put with the strike price of $20. The stock goes down to $15. I close the put and realize a net gain of $3 ($5 minus $2 premium). Right?

So here is what I don’t understand: I expect the seller of the put is hoping that the stock stays the same or goes up so that I do not exercise the put and sell or buy the stock. But if is goes down so that I want to exercise my rights under the put contract, it is not clear what happens.

When I exercise the put, the seller of the put parts with his stock, which he committed to selling at $20, but now is worth $15. Where does the $5 come from to fund my realization of gain? Out of pocket from the seller? He has the $2 of the premium, but it seems he has to make up the other $3 with cash.

RE: Selling covered calls: If the worst happens to the seller, namely that the price goes up and the call buyer exercises his option, it is not so bad: the seller did get a what once was fair price for the stock plus the premium. He might have missed out on some upside gain, but it was never really his, so the loss of said upside gain is not so painful.

RE: Selling covered puts, I assume they are covered, when the buyer of the put exercises the option, A.) the seller gives up the stock at a lower price and B.) has to also part with the difference between the strike price and the current price, in this case $5 ($3 cash and the $2 premium). It seems a lot more painful to experience an actual out of pocket cash loss than missing out on a potential gain. Am I close to understanding this?

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Larry,

You seem to have some ideas in place, but this disucssion of put options is discouraging.

You do not seem to understand what a put is, or which rights granted to put owners.  Let's handle your question in sequence.

1) Yes.  Stock is $15, your put is worth $5 (or more) and you realize a minimum profit of $300 ($3 per share).

2) You NEVER know what the seller of the put hopes for.  He may have a large position in which he makes a ton of money if the stock drops.  Just because you bought one put from that trader, don't think you know anything about why he sold that put.

The seller of the put DOES NOT PART WITH HIS STOCK.  THE SELLER OF A PUT, WHEN ASSIGNED AN EXERCISE NOTICE, IS OBLIGATED TO BUY, NOT SELL STOCK.

He is committed to buying stock at the strike price of $20.  He/she does not sell stock.

In this scenario, he buys stock, paying $20 when it is worth $15.  He appears to have a loss.  But, depending on how he was hedged, he may have a profit on his whole position – even if he has a loss on this specific option.  None of this is any concern of yours.  And even if you deem it to be a concern, the information of his private transactions is not available to you.

3) Your gain is not $5, it is only $3.

4) Where does the cash come from? The person on the other side of the trade – in this case, the put seller, has a $3 loss.  Yes, he [in reality, it can be anyone who has a short position in that put.  Your connection to the person with whom you made the trade is severed as soon as the trade is made] has to come up with that $3.  Is this surprising to you?

For simplicity sake, just assume that the gain or loss was absorbed by the person with whom you made the trade.

5) Covered calls:  The worst that can happen is for the stock price to tumble and you lose a lot of money.

Your scenario of 'the worst that can happen' is actually the BEST that can happen.  It gives you the maximum possible profit for the chosen strategy. What I cannot understand is why you believe this is the worst case.

Would you rather make a profit that is less than the meximum you might have earned, or lose $1,000?  I think the choice is clear. This is important. This is a crucial concept.  You must understand this concpet.

If you believe that the best possible result is 'the worst that can happen' you must – I mean must – go back to square one and begin learning about options all over again.  This time use a different source to learn.  I suggest The Rookie's Guide to Options.

6) A covered put position consists of 100 shares of SHORT stock plus one SHORT put option. That is NOT the situation you are desscribing.  Long stock and short one put is not a covered put. 

a) The seller of the put does not 'give up' the stock at the lower price.  He/she must BUY more stock at the higher strike price.  This is the definition of a put option.  Do not shrug off this point.  It is essestial.

b) The put seller, and person forced to buy stock at $20 per share, does not have to part with any money at any specific point in time.  Yes, if that seller chooses to exit the trade at the point when he/she is assigned an exercise notice, then $3 per share is lost on the trade.  However, there is no requirement that the trade be closed at this time.

7) If this is truly a COVERED PUT, then the assignment, forcing the purchase of shares, offsets the original SHORT stock position for the covered put writer.

Conclusion

NO. YOU ARE NOT EVEN CLOSE. TO UNDERSTANDING.  Please do yourself a big favor and start all over again.  Do not skimp on time.  Read the most basic concepts about options.

Larry you can do this.  You just have some bad misconceptions and they can be unlearned – if you work with an open mind.

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