Previously, we saw that the Put option buyer and seller are two sides of the same coin. Their outlooks are poles apart; if the put buyer is pessimistic with regards to the market, then the opposite must be true for the writer. In the last chapter, we studied Bank Nifty’s chart through the eyes of a put buyer; now let’s re-examine it from a different viewpoint- that of a put option seller.
The typical mindset of a Put Option Seller would follow a similar pattern as outlined below:
You may be wondering at this point why, if the outlook is bullish, you will write (sell) a put option rather than simply buying a call option?
Ultimately, the decision to buy or sell an option comes down to the attractiveness of the premium. We can purchase the call option if it has a low premium, while opting to sell the put option makes more sense if it is trading at a high premium. To comprehend what is most favourable, we need to be knowledgeable in ‘option pricing’. Fortunately, this module will expand our understanding of this.
The trader, thus, opts to write the 18400 Put option and earns a premium of Rs.315. Let us examine the Profit & Loss (P&L) pattern for a Put Option seller and deduce certain findings.
– Understanding Profit & Loss (P&L) behaviour for the put option seller
It’s important to remember that the intrinsic value of the option remains identical whether you are writing a put option or buying one. Afterwards, we’ll consider various possible outcomes when the option expires and analyse how this affects the P&L.
I presume you are now able to comprehend the P&L effects at maturity, since we have done so for the three previous chapters. The following summarizes the generalizations to bear in mind (noting row 8 denotes the strike price of this trade) –
This formula can be used to determine the profit and loss from writing a Put option, provided that the position is held until expiry. Here’s something to note:
Premium Received – [Max (0, Strike Price – Spot Price)]= P&L
Let’s pick random numbers and see how the formula works:
Spot price: 17200
Spot price: 19000
For the spot price of 17200 (below the strike price), indicating a loss-making position:
P&L = 315 – Max (0, 18400 – 17200)
= 315 – Max (0, 1200)
= 315 – 1200
For the spot price of 19000 (above the strike price), indicating a profitable position limited to the premium received:
P&L = 315 – Max (0, 18400 – 19000)
= 315 – Max (0, -600)
Both results align with the expected outcome.
The breakdown point for a put option seller, where they begin to incur losses after surrendering the entire premium received, can be calculated using the formula:
Breakdown point = Strike Price – Premium Received
For Bank Nifty, let’s assume the premium received is 250:
Breakdown point = 18400 – 250= 18150
At the breakdown point of 18150, the put option seller neither gains nor loses. To verify this, we can use the P&L formula:
P&L = 250 – Max (0, 18400 – 18150)
= 250 – Max (0, 250)
= 250 – 250
The result confirms the expectation of the breakdown point.
– Put option seller’s Payoff
By plotting the P&L points from the table and creating a line graph, we can visualize the general patterns and trends in the Put option seller’s P&L.
From the graph, it is clear that 18400 is the strike price. Here are some points to be noted:
Hopefully, by now, you should have understood the basics of selling Put Options. We’ve discussed Call and Put Options from both buyers’ and sellers’ perspectives over the preceding chapters. In the next one, we’ll quickly recap before moving on to other essential Option concepts.