Writing put options is making the ability to sell a stock, and trying to give this right, to someone else for a specific price; this is a right to sell the underlying but not an obligation to do so.
As we know, the put option gives the holder the right but not the obligation to sell the shares at a predetermined price. Whereas, in writing a put option, a person sold the put option to the buyer and obliged himself to buy the shares at the strike price if exercised by the buyer. The seller, in return, earns a premium, which is paid by the buyer and committing to buy the shares at the strike price.
In the first scenario, the stock price falls below the strike price ($60/-), and hence, the buyer would choose to exercise the put optionPut OptionPut Option is a financial instrument that gives the buyer the right to sell the option anytime before the date of contract expiration at a pre-specified price called strike price. It protects the underlying asset from any downfall of the underlying asset anticipated.read more. As per the contract, the buyer has to buy the shares of BOB at a price of $70/- per share. In this way, the seller would buy the 100 shares (1 lot is equal to 100 shares) of BOB for $7,000/- whereas the market value of the same is $6000/- and making a gross loss of $1000/-. However, the writer has earned an amount of $500/- ($5/ per share) as premium incurring him a net loss of $500/- ($6000-$7000+$500).
In the second scenario, the stock price falls below the strike price ($65/-), and hence, the buyer would again choose to exercise the put option. As per the contract, the buyer has to buy the shares at a price of $70/- per share. In this way, the seller would buy the 100 shares of BOB for $7,000/- whereas the market value now is $6500/- incurring a gross loss of $500/-. However, the writer has earned an amount of $500/- ($5/ per share) as premium making him stand at a break-even point of his trade with no loss and no gain ($6500-$7000+$500) in this scenario.
In our last scenario, the stock price soars above instead of falling ($75/-) strike price and hence, the buyer would rather not choose to exercise the put option as exercising put option here does not make sense or we can say that no one would sell the share at $70/- if it can be sold in the spot market at $75/-. In this way, the buyer would not exercise the put option leading the seller to earn a premium of $500/-. Hence, the writer has earned an amount of $500/- ($5/ per share) as premium making a net profit of $500/-
In writing put options, a writer is always in profit if the stock price is constant or move in an upward direction. Therefore, selling or writing put can be a rewarding strategy in a stagnant or rising stock. However, in the case of falling stock, the put seller is exposed to significant risk, even though the seller risk is limited as the stock price cannot fall below zero. Hence, in our example, the maximum loss of put option writer can be $6500/-.
The different notations used in the option contractOption ContractAn option contract provides the option holder the right to buy or sell the underlying asset on a specific date at a prespecified price. In contrast, the seller or writer of the option has no choice but obligated to deliver or buy the underlying asset if the option is exercised.read more are as follows:
A put option gives the holder of the option the right to sell an asset by a certain date at a certain price. Hence, whenever a put option is written by the seller or writer, it gives a payoff of zero (since the put is not exercised by the holder) or the difference between stock price and the strike price, whichever is minimum. Hence,
As the name suggests, in writing a covered put strategy, the investor writes put options along with shorting the underlying stocksShorting The Underlying StocksShort sale of stocks also known as shorting is a process of selling the borrowed stocks. Trader borrows the security from the broker and then sells it in the open market and thereafter, buys the security back at an appropriate time to pay it back to the broker.read more. This Options Trading strategyOptions Trading StrategyOptions trading refers to a contract between the buyer and the seller, where the option holder bets on the future price of an underlying security or index.read more is adopted by the investors if they strongly feel that stock is going to fall or to be constant in the near term or short term.
As the share prices fall, the holder of the option exercises at the strike priceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more, and the stocks are purchased by the writer of the option. The net Payoff for the writer here is premium received plus income from shorting the stocks and cost involved in buying back those stocks when exercised. Therefore, there is no downside risk, and the maximum profit than an investor earns through this strategy is the premium received.
On the other hand, if prices of underlying stocks rise, then the writer is exposed to unlimited upside risk as the stock price can rise to any level, and even if the option is not exercised by the holder, the writer has to buy the shares (underlying) back (because of shorting in the spot marketSpot MarketThe spot market, often called a cash/physical market, is a financial market where stocks, bonds and currencies are bought and sold for delivery with a usual settlement time of two business days from the day the trade was initiated (T+2). The settlement price is called the spot price.read more),
In the first scenario, when the share prices close below the strike price at expiration, then the option will be exercised by the holder. Here, the Payoff would be calculated in two steps first, while the option is exercised, and second when the writer buys back the share.
The writer is in a loss in the first step as he is obliged to buy the shares at the strike price from the holder, making the pay off as the difference between stock price and strike price adjusting with the income received from premium. Hence, the Payoff would be negative $10/ per share.
In the second scenario, when the share price rallies to $85/- at expiration, then the option will not be exercised by the holder leading a positive payoff off of $5/- (as premium) for the writer. Whereas in the second step, the writer has to buy back the shares at $85/- which he sold at $75/- incurring a negative payoff of $10/-. Therefore, the net Payoff for the writer in this scenario is negative $5/- per share.
Writing uncovered put, or naked putNaked PutA naked put (NP) is a bullish options strategy wherein the investor writes (sells) a put option without having a short position on the underlying stock.read more is in contrast to a covered put option strategy. In this strategy, the seller of the put option does not short the underlying securities. Basically, when a put option is not combined with the short positionShort PositionA short position is a practice where the investors sell stocks that they don't own at the time of selling; the investors do so by borrowing the shares from some other investors to promise that the former will return the stocks to the latter on a later date.read more in the underlying stock, it is called writing uncovered put option.
Profit for the writer in this strategy is limited to the premium earned, and also there is no upside risk involved since the writer does not short the underlying stocks. On one side where there is no upside risk, there is a huge downside risk involved as the more the share prices fall below strike price more, and the loss writer would incur. However, there is a cushion in the form of a premium for the writer. This premium is adjusted from the loss in case the option is exercised.
Looking at the payoffs, we can establish our argument that the maximum loss in uncovered put option strategy is the difference between the strike price and stock price with the adjustment of the premium received from the holder of the option.
In an options trade, the buyer needs to pay the premium in full. Investors are not allowed to buy the options on margins since options are highly leveraged, and buying on marginBuying On MarginBuying on margin is defined as an investor who purchases an asset, say stock, home, or any financial instrument, and makes a down payment, which is a small portion of asset value. The balance amount is financed through a bank or brokerage firm loan. The asset purchased will serve as collateral for an unpaid amount.read more would increase these leverage at a significantly higher level.
However, an option writer has potential liabilities and therefore has to maintain the margin as the exchange and broker has to satisfy itself in a way that the trader does not default if the option is exercised by the holder.
If you buy an option to buy futures, you own a call option. If you buy an option to sell futures, you own a put option. Call and put options are separate and distinct options. Calls and puts are not opposite sides of the same transaction.
When buying or selling an option, you must choose from a set of predetermined price levels at which you will enter the futures market if the option is exercised. These are called strike prices. For example, if you choose a soybean option with a strike price of $12 per bushel, upon exercising the option you will buy or sell futures for $12. This will occur regardless of the current level of futures price.
When buying an option you must choose which delivery month you want. Options have the same delivery months as the underlying futures contracts. For example, corn options have December, March, May, July, and September delivery months, the same as corn futures. If you exercise a December corn option you will buy or sell December futures. 781b155fdc