The market value must remain at a stable enough price so that the option can be purchased below initial sales price, even if it is in the money. The decline in time value still occurs, even when accompanied by consistent levels of intrinsic value.
Example: Setting Limits: You have advised your broker that you intend to write uncovered calls. Your portfolio currently is valued at $20,000 in securities and cash. Your broker restricts your uncovered call writing activity to a level that, in the broker’s estimation, would not potentially exceed $20,000. However, as market conditions change, your portfolio value could fall, in which case your broker has the right to restrict your uncovered call activity to a lower dollar amount, or even to require you to deposit additional funds. When you do not have funds available, the brokerage firm has the right to sell some of your securities to cover the shortfall.
Potential loss in call writing is conceivably unlimited because no one knows how high a stock’s price could rise. Put writers, in comparison, face a limited form of potential loss. The maximum is the difference between the striking price and zero; in practical terms, the real risk level is the difference between striking price and tangible book value per share.
Example: Worst Case, But Limited: You want to write puts in your portfolio as part of your investment strategy. Your portfolio is valued at $20,000. Your brokerage firm will place restrictions on uncovered put writing activity based on an estimation of potential losses. However, when you write puts, your liability is not as great; stocks can fall only so far, whereas they can rise indefinitely. So the worse case for selling puts is known; it is the striking price of the short puts.
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Tags: investing, options, stocks
