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NOTE: By "covered put" we mean covered by a short position, not a cash-secured put.

I have the following question from my SIE textbook:

If a customer had a large cash position and was interested in purchasing stock at prices below where they are today, and possibly generating some income in the process, an option strategy would be to

A. write covered puts that are currently out of the money.

B. write uncovered calls that are currently out of the money.

C. buy out-of-the-money calls.

D. place a buy stop order below the market.

The answer was A. with the explanation: "Writing the puts would generate premium income. If the stock declines in value and the option is exercised, he will by the stock at a price that’s lower than where the market is at this moment. The short calls would force him to sell the shares if exercised. Buying out-of-the-money calls cost money, and the strike price would be higher than the market. The buy stop does not generate income"

I get why C,D are wrong. Both answers A and B have unlimited risk since a covered put doesn't protect from the short position you have, and the uncovered call requires the selling of shares you don't have. Both answers A and B will be profitable if the share price goes down (the OTM call premium). So what's wrong with B?

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2 Answers 2

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There are two objectives cited in the question, purchasing a stock at a lower price and generating some income now.

Answer A is correct as is the explanation

B. Writing out-of-the-money uncovered calls generates income but does not give you the opportunity to acquire the stock at a better price

C. Buying out-of-the-money calls satisfies neither objective

D. Placing a buy stop order below the market. has the potential for acquiring the stock below current price but generates no income

Only B has theoretically unlimited risk.

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  • Only B has unlimited risk? For A, a covered put means we have a short position. That has unlimited risk, correct? The put is worthless as the share price goes up, so the premium is all we collect, and now we have to worry about our short position
    – Cotton Headed Ninnymuggins
    Commented Jun 7 at 23:21
  • And also, why would the uncovered call need to "give you the opportunity to acquire the stock at a better price"? Can't you just buy it at the better price when the price falls?
    – Cotton Headed Ninnymuggins
    Commented Jun 7 at 23:23
  • The question was "interested in purchasing stock at a lower price and generating some income in the process". A cash secured put (CSP)would achieve that - collect some premium and buy the stock at a lower price. A covered put (short stock and short put) would achieve that as well. I interpreted the question to mean a the CSP. I think that the answer supports that since there's no mention of the gain on the short stock. It's a poorly phrased question. For my interpretation, (A) should have said: Write OTM cash secured put. That removes the ambiguity.
    – Bob Baerker
    Commented Jun 8 at 22:35
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Keep in mind what a call is. These are contracts that give the option owner to buy that particular stock for that particular price. When you write an uncovered call (aka sell an uncovered call), then you commit to selling that particular stock, at that particular price. If the call buyer exercises the option, then you end up selling the stock, not buying it.

Since the goal is to start a position, selling calls do not help.

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  • And in the case of a covered put, we also don't "start a position" if the price goes up either. I truly don't understand why A is the objective answer when both positions take on unlimited risk and benefit if the stock price drops as anticipated.
    – Cotton Headed Ninnymuggins
    Commented Jun 13 at 6:21
  • A short sale commits us to returning the stock. A call commits us to selling the stock. What's the difference?
    – Cotton Headed Ninnymuggins
    Commented Jun 13 at 6:23
  • @CottonHeadedNinnymuggins yeah, but the question says the client is interested in purchasing stock at prices below where they are today. The client wants to start a position, if they're able to buy the stock at prices lower than where they currently are. If you sell calls, you can't buy the stock at prices lower than where they currently are. Note also there is no prediction that the stock price is going to drop. If you are predicting the price will drop, you buy puts, not sell them.
    – Allure
    Commented Jun 13 at 6:26
  • Let me confirm what a covered put is, because maybe I don't understand that piece. Is this an example of a covered put?: You borrow 100 shares and sell an OTM put. If so, then when the price goes down and the option is exercised you buy the shares and close your short position. You still don't own shares at the end of this
    – Cotton Headed Ninnymuggins
    Commented Jun 13 at 6:33
  • @CottonHeadedNinnymuggins I see what you mean. Like Bob Baerker I also assumed this is a cash-secured put, which seems like the obvious way to achieve what the client wants. If it's a covered put then you are indeed predicting the price will fall. which is not what the client wants. As stated, you can probably argue that "none of the above" is the appropriate answer to the question.
    – Allure
    Commented Jun 13 at 6:42

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