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This is a level 2 question.
I'm a new to options trading, and I've started with a few paper trades. I sold the ABC August 52.50 put for 1.40 when the stock was trading at 57.63. The option price has dropped to 0.10 the day before expiration and will in all likelihood finish out of the money. How do I calculate my gain on the trade? What is the downside to selling options?
Since your initial "investment" for a put-sell trade will be your broker's margin requirement, we prefer to calculate the return on margin (ROM) for these trades. The maximum profit for a put sell, which occurs if the option expires worthless, is the premium received (less any commission). To calculate the ROM, simply divide the maximum profit by the margin requirement for the trade. Margin requirements for put sells will vary among brokers, so check with your current broker so that you can calculate an accurate ROM.
Let's do a specific example using the information from your ABC paper trade. The fact that the option is 0.10 on the day before expiration is irrelevant. All that matters is that the option expires worthless, allowing you to pocket the entire premium of $140 per contract. For this example, we'll use a common margin requirement according to the following formula: [20% of the current stock price plus the premium received less the out-of-the-money amount of the option] times 100. In your example, the margin requirement would be $779.60 [(57.63*0.20)+1.40-(57.63-52.5)*100]. Thus, the ROM would be 18% (140 divided by 779.60).
As to your second question, there is significant downside risk to put selling. If the price of the underlying stock goes down, there is a risk that you could be assigned the stock. That is, as the put seller, you are obligated to purchase the underlying shares at the put's strike price should the holder decide to exercise the put.
If the stock price falls below the strike price of the sold put, the put writer can partially remedy this situation by buying back the put to close the position, which will typically result in a modest loss. However, if the stock price falls rapidly just before expiration, there may be little that the put writer can do to avoid assignment.
Because there is this assignment risk, we often recommend writing puts on good quality stocks that you would eventually like to include in your portfolio. In this way, if the equity does take a temporary dip and you are assigned the stock, you have acquired a security that you want to own at a discounted price.
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Question Level Key
Level One--Basic Jargon, Definitions, Basic Mechanics of Trading.
Level Two--Introductory Points, Practical Points and Simple Strategies
Level Three--More Advanced Strategies and Repairs
Level Four--Risk Management, Psychology, and How Best to Evaluate Things.
Level Five--High end questions concerning Portfolio Analysis, Managing a Portfolio
of Options, Option Pricing Models, and Nuances of Trading. Included could be a variety of
other topics.
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