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 Selling put option

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Options

• Basics of call options
• Basics of options jargon
• How to buy a call option
• How to buy/sell call option
• Buying put option
• Selling put option
• Call & put options
• Greeks & calculator

• Option contract
• The option greeks
• Delta
• Gamma
• Theta
• All volatility
• Vega

6.1 – Building the case

An option seller and a buyer are similar to two sides of the same coin, as we previously understood. They view markets in diametrically opposed ways. According to this, the put option seller must have a bullish view of the markets if the put option buyer is bearish about the market. Remember that we examined the Bank Nifty chart in the previous chapter? We’ll do so again, but this time from the viewpoint of a put option seller.

 

The put option seller’s typical thought process would be as follows:

Trading for Bank Nifty is at 18417.
a week ago Bank Nifty tested the 18550 level of resistance (resistance level is highlighted by a green horizontal line)
Since there is a price action zone at this level that is evenly spaced in time, 18550 is regarded as resistance (for people who are not familiar with the concept of resistance I would suggest you read about it here)
The price action zone is highlighted in a blue rectangular box.
For three consecutive attempts, Bank Nifty has made an effort to break through the resistance level.

 

All it needs is one strong push—possibly the announcement of respectable results by a sizable bank. ICICI, HDFC, and

 

SBI is anticipated to announce results soon.)

 

A favourable cue and a move above the resistance will send the Bank Nifty on an ascent.

 

So it might make sense to write the Put Option and collect the premiums.

 

At this point, you might be wondering why write (sell) a put option rather than simply purchase a call option if the outlook is bullish.

 

Well, the decision to either buy a call option or sell a put option really depends on how attractive the premiums are. At the time of taking the decision, if the call option has a low premium then buying a call option makes sense, likewise if the put option is trading at a very high premium then selling the put option (and therefore collecting the premium) makes sense. Of course to figure out  what exactly to do (buying a call option or selling a put option) depends on the attractiveness of the premium, and to judge how attractive the premium is you need some background knowledge on ‘option pricing’. Of course, going forward in this module we will understand option pricing

 

 

Assume the trader decides to write (sell) the 18400 Put option and receive Rs. 315 as the premium in light of the foregoing considerations. Let’s observe the P&L behaviour for a Put Option seller as usual and draw some conclusions.

It’s important to remember that margins are blocked in your account when you write options, whether they are Calls or Puts. We have talked about this viewpoint here; we ask that you do the same.

6.2 – P&L behavior for the put option seller

Please keep in mind that whether you are writing a put option or purchasing a put option, the intrinsic value of the option is still calculated in the same way. The P&L calculation does, however, change, as we will soon discuss. On the expiration date, we’ll make a variety of assumptions to determine how the P&L will behave.

 

 

As we have done the same for the previous three chapters, I would assume that by this point you will be able to generalise the P&L behaviour upon expiry with ease. The generalisations are as follows (pay close attention to row 8 because that is the trade’s strike price):

 

 

Selling a put option is done in order to receive the premiums and profit from the market’s bullish outlook. As a result, the profit (premium collected) remains constant at Rs. 315 so long as the spot price exceeds the strike price.

 

Generalization 1: Put option sellers make money as long as the strike price is met or exceeded by the spot price. To put it another way, only sell a put option if you are bullish on the underlying or when you think it will stop falling.
The position begins to lose money as soon as the spot price drops below the strike price (18400). There is obviously no limit to the amount of loss the seller can sustain in this situation, and it is theoretically unlimited.

 

Generalization 2: When the spot price drops below the strike price, the seller of a put option may incur an unlimited loss.

 

Here is a general formula using which you can calculate the P&L from writing a Put Option position. Do bear in mind this formula is applicable on positions held till expiry.

P&L = Premium Recieved – [Max (0, Strike Price – Spot Price)]

Let us pick 2 random values and evaluate if the formula works –

  • 16510
  • 19660

 

@16510 (spot below strike, position has to be loss making)

= 315 – Max (0, 18400 -16510)

= 315 – 1890

= – 1575

@19660 (spot above strike, position has to be profitable, restricted to premium paid)

= 315 – Max (0, 18400 – 19660)

= 315 – Max (0, -1260)

=  315

 

 

Clearly both the results match the expected outcome.

Further, the breakdown point for a Put Option seller can be defined as a point where the Put Option seller starts making a loss after giving away all the premium he has collected –

Breakdown point = Strike Price – Premium Received

For the Bank Nifty, the breakdown point would be

= 18400 – 315

= 18085

 

 

So as per this definition of the breakdown point, at 18085 the put option seller should neither make any money nor lose any money. Do note this also means at this stage, he would lose the entire Premium he has collected. To validate this, let us apply the P&L formula and calculate the P&L at the breakdown point –

 

= 315 – Max (0, 18400 – 18085)

= 315 – Max (0, 315)

= 315 – 315

=0

The result obtained is clearly in line with the expectation of the breakdown point.

 

 

 

 

6.3 – Put option seller’s Payoff

The generalisations we have made about the Put option seller’s P&L should be visible if we connect the P&L points (as shown in the earlier table) and create a line chart. Please find the same below.

 

Here are a few things that you should appreciate from the chart above, remember 18400 is the strike price –

  1. The Put option seller experiences a loss only when the spot price goes below the strike price (18400 and lower)
  2. The loss is theoretically unlimited (therefore the risk)
  3. The Put Option seller will experience a profit (to the extent of premium received) as and when the spot price trades above the strike price
  4. The gains are restricted to the extent of premium received
  5. At the breakdown point (18085) the put option seller neither makes money nor losses money. However at this stage he gives up the entire premium he has received.
  6. You can observe that at the breakdown point, the P&L graph just starts to buckle down – from a positive territory to the neutral (no profit no loss) situation. It is only below this point the put option seller starts to lose money.

 

And with these ideas, you’ve hopefully grasped the essence of selling put options. In the previous chapters, we examined the call option and the put option from the viewpoints of the buyer and the seller. We will briefly review the same in the following chapter before moving on to other crucial Options concepts.