General Securities Representative (Series 7) Practice Exam

What happens to the premium received by the put option writer when the option is assigned?

1. It is forfeited

2. It increases the cost basis

3. It decreases the cost basis

4. It is treated as a liability

The correct answer is: It decreases the cost basis

When a put option is assigned, the writer of the option is obligated to purchase the underlying asset at the strike price. In this scenario, the premium received for writing the put option is factored into the cost basis of the asset that the writer acquires. Specifically, this premium effectively reduces the writer's overall cost basis in the underlying asset because the writer has already received that premium upfront, which acts as a credit against the purchase price. For instance, if a put option with a strike price of $50 is assigned and the writer received a premium of $5 for writing the option, the writer ends up purchasing the asset for $50. However, considering the $5 premium received, the net cost basis of the underlying asset will be reduced to $45. This reduction reflects the idea that the writer has already received compensation for taking on the risk of the put option. This understanding is crucial for comprehending how options trading influences potential future capital gains or losses for investors. Hence, recognizing the impact of the premium on the cost basis is essential for accurate investment analysis and tax reporting.