6.1 - Case study

We understood previously that an option seller and buyer were like two sides to the same coin. They may have an opposing view of markets. This means that if the buyer of a put option is negative about the market, the seller must be bullish. Remember that we reviewed the Bank Nifty chart in Chapter 1. We will now review it from the viewpoint of a seller of put options.

(IMAGE 1)

This is the typical thinking process of the Put Option Seller.

1. Bank Nifty trades at 18417
2. Bank Nifty's resistance level was tested at 18550 on 2 July (resistance is marked by a horizontal green line).
3. 18550 is considered resistance due to a well-paced price action area at this level. (I recommend that you learn more about resistance if you aren't already familiar with it.
4. In a set of blue rectangular boxes, I highlighted the price action area.
5. Bank Nifty attempted to break the resistance level three consecutively over the past 3 years
6.    One  push is all it takes (perhaps a bank that announces decent Results - HDFC or ICICI are expected soon to announce results).  
7. Bank Nifty will be on an upward trajectory if it receives a positive cue and moves above resistance
8. Writing the Put Option and collecting premiums might sound good.

This stage may pose a problem for you: If the outlook is bullish why sell a put option when you can just buy a option?

The attractiveness of the premiums will determine whether you decide to buy or sell a call option. If the premium for the call option is low, then it makes sense to buy a call option. However, if the premium for the put option trades at a high premium, then selling the option and collecting the premium makes sense. The attractiveness of the premium will determine what you do. To know how to decide whether to buy a call option, or sell a put option, you must have some knowledge about 'option pricing'. We will be covering option pricing in the next module.

These thoughts are what we will use to assume that the trader writes (sells) the 18400 Put Option and receives Rs.315 in premium. Let's look at the P&L of a seller of Put Option and make some generalizations.

Please note that margins in your account are blocked when you write options, regardless of whether they are Calls or Puts. This perspective has been discussed here. You are invited for the same.
 

6.2 - P&L behavior 

Remember that the calculation of the intrinsic price of an option is the same whether you write a put or buy a put option. The P&L calculation is different, as we'll discuss in detail. Let's assume that the expiry date is different from what actually happens and then see how the P&L reacts.
(CHART)
 

Given that you have done so for the previous 3 chapters, I assume that you should be able to quickly generalize the P&L behavior at expiry. These generalizations can be found below (be sure to pay attention to row 8, which is the strike price for this trade).

1. Selling a put option is done to collect premiums and profit from bullish market outlook. As you can see, the profit remains flat at Rs.315 (premium received) as long the spot price is above the strike price.
   1. Generalization 1-Put Options sellers can be financially profitable as long as spot prices are at or above their strike price. If you believe the price will fall, or are bullish about the underlying, then you should not sell a put option.
2. The seller's position begins to lose money when the spot price drops below the strike price (18400). There is no limit to the amount of loss that the seller can suffer here, and theoretically it could be infinite.
   1. Generalization2 when the spot price goes lower than strike price,a put option seller can experience a loss that too unlimited.
      This is how you calculate the P&L for a Put Option position. This formula can be used for positions that are held until expiry.

P&L =
Premium Received - [Max (0. Strike Price – Spot Price)

Let's take 2 random numbers and see if this formula works.

• 16510
• 19660

@16510

= 315 - Max (0.18400 -16510)

= 315 -1890

= -1575

@19660 Position must be profitable and not restricted to premium payments

= 315 – Max (0, 18400-6600)

= 315 - Max (0. -1260).

= 315

Both the expected and actual results are evident.

The breakdown point for a Put Option Seller can also be described as the point at which he starts to lose money after giving away all his premium.

   Breakdown point=
Strike price - premium received  

The breakdown point for the Bank Nifty would be

= 18400 - 315.

= 18085

According to this breakdown point definition, at 18085, the put option seller shouldn't make or lose any money. This also means that he will lose all of the Premium he has earned. Let's use the P&L formula to calculate the P&L at breakpoint.

= 315 – Max (0, 18400-18085)

= 315 - Max (0. 315)

= 315 - 315.

= 0

The obtained result is in accordance with the expectations of the breakdown point.

6.3 - Put Option Payoff for Seller

We can see the generalizations that we made about the P&L of the seller of put options if we connect them (as shown in the table).
(image 2
 

These are some things you should take into consideration from the chart. Remember that 18400 is the strike rate.

1. Only when the strike price is lower than the spot price (18400 or lower), does the Put option seller suffer a loss.
2. The theoretical loss is unlimited (therefore, the risk).
3. A Put Option seller will make a profit if the spot price trades higher than the strike price.
4. The premium received is the limit on the gains
5. The put option seller does not make money or lose money at the breakdown point (18085). He must give up all the premium he received at this point.
6. It is evident that the breakdown point causes the P&L graph to drop from a positive territory down to a neutral (no loss, no profit) position. The put option seller begins to lose money below this point.

These points should help you understand the basics of selling Put Option. In the previous chapters, we looked at the call option as well as the put option from both buyers and sellers perspectives. We will summarize these concepts quickly and then shift to other important concepts about Options in the next chapter.

Keypoints

1. If you believe that the stock will not fall, or if you are bullish about it, you can sell a put option
2. If you're bullish on the underlying, you can either sell a call option or buy the call option. It all depends on how attractive your premium is
3. You can get an idea of the attractiveness of Option Premium pricing by comparing it with Option Greeks
4. Both the buyer and seller of put options have asymmetrically opposite P&L behavior
5. You get premium if you sell a put options
6. You must deposit margin to sell a put option
7. Your profit margin is only as high as the premium you get, but your potential loss could be unimaginable when you sell a put-option.
8.    P&L=
   Premium received-Max[o,(strike price-spot price)]  
9. Breakdown point = Strike price - Premium received