Put Option Selling strategies and Techniques for Profitable Trading

Building the Case

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 reexamine 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:

Bank Nifty has touched 51,200 today

Two days back, Bank Nifty met its impediment at 51,800 (this resistance is marked by a green horizontal line)

Resistance can be found at 51,800 due to the presence of a price action zone that has been established over a span of time

I drew blue rectangular boxes to indicate the price action zone

Bank Nifty has tried to break through the resistance level on three occasions

The economy is poised for a recovery, and it’s just a matter of time before things start picking up. A single positive event, such as a prominent financial institution reporting strong financial results, could act as a catalyst

An encouraging signal combined with a breakthrough the resistance will propel Bank Nifty on an upward journey

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, whilst 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 51,200 Put option and earns a premium of Rs 420. 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 summarises the generalisations to bear in mind (noting row 8 denotes the strike price of this trade):

The purpose of selling a put option is to generate income through collecting premiums whilst taking a bullish stance on the market. Hence, as observed, the profit remains constant at Rs 420, representing the premium collected, as long as the spot price remains higher than the strike price

Sellers of Put Options can benefit if the spot price stays at or above the strike rate. Therefore, you should purchase a put option only if you are confident about the underlying asset, or anticipate that it will not continue to drop.

The strike price (51,200) is lower than the spot, suggesting that this position may suffer a loss. In theory, a seller can also experience infinite loss

The holder of a put option can sustain potential, unlimited losses if the spot price falls below the strike price.

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: 49,100

Spot price: 52,500

For the spot price of 49,100 (below the strike price), indicating a loss-making position:

P&L = 420 – Max(0, 51,200 – 49,100)

= 420 – Max(0, 2,100)

= 420 – 2,100

= -1,680

For the spot price of 52,500 (above the strike price), indicating a profitable position limited to the premium received:

P&L = 420 – Max(0, 51,200 – 52,500)

= 420 – Max(0, -1,300)

= 420

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 420:

Breakdown point = 51,200 – 420

= 50,780

At the breakdown point of 50,780, the put option seller neither gains nor loses. To verify this, we can use the P&L formula:

P&L = 420 – Max(0, 51,200 – 50,780)

= 420 – Max(0, 420)

= 420 – 420

= 0

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 visualise the general patterns and trends in the Put option seller’s P&L. Let’s take a look at the following example:

From the graph, it is clear that 51,200 is the strike price. Here are some points to be noted:

The Put option seller endures a decrease only when the spot rate drops below the strike price of 51,200

Theoretically, the potential loss of a position is unlimited, and consequently, the risk involved is also unlimited

A Put Option seller will gain an advantage relative to the premium received when the spot price is greater than the strike price

The profits are limited to the amount of premium received

At the 50,780 breakdown point, the put option seller neither earns nor incurs a loss. Yet he relinquishes the full premium he was given

At the breakdown point, we can see the P&L graph beginning to dip from a positive to a neutral region. Put option sellers start to experience losses below this line

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.

For those exploring equity investment opportunities through a stock broker or consulting with a financial advisor, understanding put option selling mechanics proves essential when navigating the stock market. Whether evaluating trading calls or utilising a stock screener to identify opportunities, comprehending put option writing strategies enables more sophisticated premium collection strategies whilst managing unlimited risk exposure.

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