Writing put is a strategy of advanced options traders since, in the worst-case scenario, the stock is assigned to the put writer (they have to buy the stock), while the best-case scenario is that the writer retains the full amount of the option premium.
This article clearly explains put writing, the best strategies for put writing and how to make money writing puts. Let’s dive in!
Table of contents
What Is Put?
A put is a trading or investing method that can be used to make money or purchase stocks for less. A put writer commits to purchasing the underlying stock at the strike price in the event that the contract is exercised.
In this context, writing refers to the act of selling a put contract in order to open a position. The writer also receives a premium or fee for beginning a position by selling a put; nevertheless, they are obligated to the put buyer to buy shares at the striking price if the underlying stock drops below that level, up until the options contract expires.
According to investopedia, profit on put writing is restricted to the premium received, yet losses can be rather substantial, should the price of the underlying stock drop below the strike price.
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Writing Puts Options Defined
Writing puts refers to the act of selling a contract under which you promise to purchase stocks at a specified price (referred to as the strike price) by a specified date (known as the expiry date). A little sum (referred to as the premium) is also paid to the trader for taking a position or for putting a put contract on the market. Selling a put contract is virtually the same as writing one.
When you anticipate that the market price of shares will either increase or remain constant, you will typically write a put. Put writing is, thus, a bullish trading strategy.
Writing put options is also referred to as selling put options.
How Does Writing Put Options Work?
As we know, the right to sell the shares at a predetermined price is granted by the put option, but not the responsibility. In contrast, when a put option is written, the writer commits to buying the shares at the strike price should the buyer exercise the option. In exchange, the buyer agrees to acquire the shares at the strike price and pays the seller a premium.
Accordingly, the put option writer, in contrast to the call option writer, has a neutral or bullish outlook on the stock or anticipates a drop in volatility.
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Put Writing Strategies
There are two ways of writing puts:
- Writing covered put
- Writing naked put or uncovered put
1. Writing Covered Put
As the name implies, while using a covered put strategy, the investor simultaneously shorts the underlying stocks and writes put options. Investors who are convinced that the stock will decrease or remain stable in the near or short term will use this options trading approach.
When the value of the shares declines, the option holder exercises at the strike price, and the option writer buys the stocks. The premium received plus earnings from shorting the stocks and the expense of purchasing the equities back after the option is executed represent the writer’s net payoff in this situation.
As a result, there is no risk of losing money, and the highest return an investor can make using this approach is the amount of the premium.
In contrast, if the price of the underlying stock increases, the writer is exposed to unlimited upside risk because the stock price can increase to any level. Even if the holder does not exercise the option, the writer must still purchase the underlying shares back (due to shorting in the spot market), and in this case, the writer only receives the premium from the holder as compensation.
Example
Assume that Mr. XYZ paid a premium of $5 and wrote a covered put option on the BOB stock for a month with a strike price of $70. 100 shares of BOB make up one lot of a put option. Since this is a covered put transaction, Mr. XYZ is here shorting the underlying, which is 100 shares of BOB, at a price of $75 per share at the time of shorting.
Let’s take a look at two possible outcomes: in the first, the share price falls below $55 at expiration, allowing the holder to execute the option; in the second, the share price rises to $85 at expiration. It goes without saying that the holder will not exercise the option in the second case. Let’s figure out the Payoff in each situation.
In the first scenario, the option will be exercised by the holder of the share prices at expiration close below the strike price. In this case, the Payoff would be determined twice: once when the option is exercised and once when the writer buys back the stock.
Since the writer must purchase the shares at the strike price from the holder in the first step, the payoff is the difference between the stock price and strike price adjusted with the income from the premium. Therefore, the Payoff would be $10 less for each share.
In the second step, the writer has to buy the shares at $55/- which he has sold at $75/- earning a positive payoff of $20/-. Therefore, the net Payoff for the writer is positive $10/- per share.
| Scenario-1 (Stock prices falls below strike price) | |
|---|---|
| Strike Price of BOB | 70 |
| Option Premium | 5 |
| Price at maturity | 55 |
| Income from shorting of shares | 75 |
In the second scenario, if the share price increases to $85 at expiration, the holder will not exercise the option, resulting in a $5 (as premium) gain for the writer. While in the second phase, the writer must purchase back the shares at $85 each after selling them for $75, incurring a $10 loss. Therefore, in this scenario, the writer’s net payoff is a negative $5 per share.
| Scenario-2 (Stock prices rallies above strike price) | |
|---|---|
| Strike Price of BOB | 70 |
| Option Premium | 5 |
| Price at maturity | 85 |
| Income from shorting of shares | 75 |
| Expenses towards buying back shares | 85 |
| Net Pay-Off | -$500/- |
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2. Writing Naked Put or Uncovered Put
A covered put option strategy contrasts with writing an uncovered put, also known as a naked put. The put option seller in this approach does not sell the underlying securities short. Writing an uncovered put option is what it means when a put option is not linked with a short position in the underlying stock.
Since the writer does not short the underlying equities in this approach, the writer’s profit is constrained to the premium received, and there is also no upside risk. While there is no upside risk, there is a significant downside risk because the loss writer would incur greater losses if share prices fell below the strike price.
Example
Assume that Mr. XYZ paid a premium of $5 and wrote an uncovered put option on the BOB stock for a month with a strike price of $70. 100 shares of BOB make up one lot of a put option. Consider the following two scenarios:
Think about these two circumstances. The holder of the option may exercise it in the first scenario, in which the share price falls below $0 at expiration, while the option may be exercised in the second scenario, in which the share price rises to $85 at expiration. In the second scenario, it goes without saying that the holder will not exercise the option. We’ll figure out the Payoff for both circumstances.
The payoffs are summarized below.
| Scenario-1 (Strike price < Stock Price) | |
|---|---|
| Strike Price of BOB | 70 |
| Option Premium | 5 |
| Price at maturity | 0 |
| Net Pay-Off | -6500 |
Table-7
| Scenario-2 (Strike price > Stock Price) | |
|---|---|
| Strike Price of BOB | 70 |
| Option Premium | 5 |
| Price at maturity | 85 |
| Net Pay-Off | 500 |
By examining the payoffs, we can support our claim that, after adjusting for the premium paid by the option holder, the greatest loss in the uncovered put option strategy is the difference between the strike price and stock price.
Writing Puts For Income
Put writing generates income because the writer of any option contract receives the premium while the buyer gets the option rights. As long as the seller is not compelled to purchase shares of the underlying stock, a put-writing technique, when executed properly, can result in gains for the seller.
The danger that the stock price could fall below the strike price and force the put-seller to purchase shares at that price is thus one of the main risks the put-seller confronts. If writing options for income, the writer’s analysis should indicate that the price of the underlying stock will remain unchanged or increase until expiration.
For instance, let’s say XYZ stock trades for $75. Put options with a strike price of $70 are trading for $3. Each put contract is for 100 shares. A put writer could sell a $70 strike price put and collect the $300 ($3 x 100) premium. In taking this trade, the writer wishes that the price of XYZ stock stays above $70 until expiry, and in a worst-case scenario at least stays above $67, which is the breakeven point on the trade.
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Puts and Call Options Defined
Put and call options are derivative assets, which means that they base their price changes on the price changes of other financial products. The financial item on which a derivative is based is frequently referred to as the underlying.
A call option is bought if the trader expects the price of the underlying asset to rise within a certain time frame. While a put option is bought if the trader expects the price of the underlying asset to fall within a certain time frame.
Puts and calls can also be written and sold to other traders. This generates income but gives up certain rights to the buyer of the option.
How Do Call Options Work?
A call is an option contract for American-style options that grants the buyer the right to purchase the underlying asset at a predetermined price at any time up until the expiration date.
Only on the expiration date may buyers of European-style options exercise their option to purchase the underlying asset. Options can have short- or long-term expirations.
The strike price of a call option is the specified price at which a call buyer can purchase the underlying asset. For instance, the buyer of a $10 strike price stock call option can use the option to purchase the shares for $10 before it expires.
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What the Call Buyer Gets
For a predetermined period of time, the call buyer has the option to purchase a stock at the strike price. They pay a premium for that privilege. The option will have intrinsic value if the price of the underlying asset rises over the strike price. The buyer has two options: either they can exercise the option or sell it for a profit, as many call buyers do (i.e., receive the shares from the person who wrote the option).
What the Call Seller Gets
The premium is given to the call writer or seller. One approach to making money is by writing call options. The income from writing a call option, however, is capped at the premium. The profit potential for a call buyer is theoretically limitless.
How to Calculate the Call Option’s Cost
One stock call option contract represents 100 shares of the underlying stock. Take the option price and multiply it by 100 to see how much it will cost you to purchase a contract.
Call options can be in, at, or out of the money:
- In the money means that the underlying asset price is above the call strike price.
- Out of the money means that the underlying price is below the strike price.
- At the money means that the underlying price and the strike price are the same.
How To Make Money Writing Puts
You can make money writing puts if the underlying stock stays below the strike price. After writing a put option, the trader profits if the price stays above the strike price. An option writer’s profitability is limited to the premium they receive for writing the option (which is the option buyer’s cost). Option writers are also called option sellers.
FAQs On Writing Puts
Put spreads come in two varieties: bull put spreads and bear put spreads.
Options trading is known to be quite risky, in part because of how complex it can be to understand. This is why it’s crucial that investors know how options work before getting involved
A put is a strategy traders or investors may use to generate income or buy stocks at a reduced price.
An investor considering using a covered put strategy is moderately bearish in the underlying company and is writing a put option to subsidize the bearish strategy cost.
Conclusion
Selling puts can be a beneficial strategy in a stagnant or rising stock since an investor is able to collect put premiums. In the case of a falling stock, a put seller is exposed to great risk, even though the profit is limited. To make the best of it, put writing is frequently used in combination with other options contracts.
References
- investopedia.com – Introduction to Put Writing
- thebalance.com – What Are Call and Put Options?
- wallstreetmojo.com – Writing Put Options
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