Q. Is there a time when you would write in-the-money puts?
A. The only occasion when you should consider writing in-the-money puts would be if you believe very strongly that the shares of the underlying security you are considering will increase in value before the option expiration date. You would receive a very large premium for writing an in-the-money put because part of the premium consists of "intrinsic" value (the amount by which the share price is less than the strike price) and part of it is "time value" (note: with an at-the-money or out-of-the-money put, all of the premium you receive initially is time value). Thus, if the share price rises above the strike price you will keep all of the option premium. The risk you face by writing in-the-money puts is that the share price does not rise and that the underlying shares are put to you (assigned) on the expiration date of the puts at a price that is higher than the current market price of the shares.
Q. After writing covered calls successfully I'd like to do put writing to increase my returns even further. Will this require more time and active management on my part?
A. Properly performed, put writing can have the same risk/reward ratio as covered call writing. Instead of buying shares for writing covered calls, you are contractually committing to purchase shares at the strike price if the put buyer wishes to exercise his option to sell the shares to you. This will typically occur on the expiration date if the market price of the shares is below the strike price. The principal difference is that you are not paying cash to acquire shares when the initial put contract is written. You are using your funds to satisfy your broker's margin requirement. Since you are typically required to post an amount of margin that is only about a third of what it would cost you to purchase the shares, it is easy to overleverage yourself by writing more put contracts than you can afford. The best way to avoid this is to limit your put writing to the number of contracts you would be able to purchase with the resources you have. For example, let's say you write ten put contracts on XYZ and the margin requirement is $10,000. The strike price on the puts is $30, so if the market price of the shares falls below $30 on the expiration date you will be required to spend $30,000 to acquire the shares. Your broker would let you initiate this put writing transaction even if you only had $10,000 in your account. Yet if the contracts are assigned you would have to have $30,000 in your account. Thus, you must make sure than you not only have $30,000 available in case the contracts are assigned, you must avoid the temptation to write other put contracts on margin even if your broker would allow it. By doing so, if all of the contracts were assigned on expiration you would not have sufficient funds to acquire all of the shares. Therefore, you would need to buy back some or the contracts, probably at a loss, in order to have sufficient cash. As long as you have not overextended yourself and you are willing to purchase the shares at the strike price if necessary on the expiration date, put writing does not require more active management than covered call writing.
Q. Could you give an example of how put option writing has the same risk/reward characteristics as covered call writing?
A. The information below demonstrates that writing at-the-money calls on shares is the functional equivalent of put writing:
Covered Call Writer
Transaction: Buy 1,000 shares of QQQQ @ $35 and write 10 $35 strike price calls @ $1.35
If shares rise in value: Calls are exercised; writer has received $1,350 in premium income
If shares decline in value: Calls expire unexercised; writer retains shares @ $35 cost; writer has received $1,350
in premium income
Transaction: Using margin (no stock purchase), write 10 $35 strike price puts at $1.35
If shares rise in value: Puts expire; writer has received $1,350 in premium income
If shares decline in value: Puts are exercised; writer purchases 1,000 shares @ $35; writer has received $1,350
in premium income.