Writing Put OptionsYou want to buy shares of a fictional company, Acme Pharmaceuticals. After reading the annual report and analyzing the financial statements, you have come to the conclusion that, in order to earn your required rate of return, you can pay no more than $25 per share. Today, the stock trades at $30 per share.
Instead of sitting around and waiting for the stock to fall to your desired price, you could write put options for the shares at $25. In essence, you would sell a promise to another party (it could be a bank, mutual fund, corporation, or individual investor) that if the shares of Acme fall below the threshold during the life of the option, the purchaser will have the right to require you to purchase those shares at $25.
Why would you agree to do this? In exchange for this promise, the buyer of your put options will pay you an insurance premium. The amount of this premium depends on a number of factors but for our purposes, assume you are paid $1.12 per share to take on this risk. If you wrote ten puts (remember that options are for round lots of 100 shares), you would receive $1,120 (10 puts x 100 shares = 1,000 shares x $1.12 premium = $1,120). If the option expires and is never exercised, you keep this money free and clear.
If the option is exercised, it serves to effectively lower your cost basis. If, for example, the price of Acme fell to $15 per share, the buyer of your put options is going to exercise their right to require you to purchase the shares at $25. Your actual cost, however, would only be $23.88 ($25 cost of shares - $1.12 premium = $23.88 net cost.)