Financial Industry Regulatory Authority (FINRA) Practice Exam

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How is the maximum loss for a put writer calculated?

Strike price + premium
Strike price - premium
Premium - strike price
Strike price / premium

The correct answer is: Strike price - premium

The maximum loss for a put writer is calculated by taking the strike price and subtracting the premium received for writing the put option. This reflects the worst-case scenario for the put writer. When a trader writes a put option, they are obligated to buy the underlying asset at the strike price if the option is exercised by the buyer. If the price of the underlying asset drops to zero, the put writer would have to buy the asset at the strike price and would lose the entire value of the asset. However, they have received a premium for writing the put, which offsets some of the loss. Therefore, the maximum loss can be expressed as: Maximum Loss = Strike Price - Premium This calculation effectively considers the scenario in which the stock becomes worthless and shows how the premium received mitigates some of the potential losses. Understanding this concept is crucial for managing risk when trading options.