Module 5   Options Theory for Professional TradingChapter 6

The Put Option selling

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6.1 – Building the case

Previously we understood that, an option seller and the buyer are like two sides of the same coin. They have a diametrically opposite view on markets. Going by this, if the Put option buyer is bearish about the market, then clearly the put option seller must have a bullish view on the markets. Recollect we looked at the Bank Nifty’s chart in the previous chapter; we will review the same chart again, but from the perspective of a put option seller.

Image 1_ Bank Nifty

The typical thought process for the Put Option Seller would be something like this –

  1. Bank Nifty is trading at 18417
  2. 2 days ago Bank Nifty tested its resistance level at 18550 (resistance level is highlighted by a green horizontal line)
  3. 18550 is considered as resistance as there is a price action zone at this level which is well spaced in time (for people who are not familiar with the concept of resistance I would suggest you read about it here)
  4. I have highlighted the price action zone in a blue rectangular boxes
  5. Bank Nifty has attempted to crack the resistance level for the last 3 consecutive times
  6. All it needs is 1 good push (maybe a large sized bank announcing decent results – HDFC, ICICI, and SBI are expected to declare results soon)
  7. A positive cue plus a move above the resistance will set Bank Nifty on the upward trajectory
  8. Hence writing the Put Option and collecting the premiums may sound like a good idea

You may have a question at this stage – If the outlook is bullish, why write (sell) a put option and why not just buy a call option?

Well, the decision to either buy a call option or sell a put option really depends on how attractive the premiums are. At the time of taking the decision, if the call option has a low premium then buying a call option makes sense, likewise if the put option is trading at a very high premium then selling the put option (and therefore collecting the premium) makes sense. Of course to figure out  what exactly to do (buying a call option or selling a put option) depends on the attractiveness of the premium, and to judge how attractive the premium is you need some background knowledge on ‘option pricing’. Of course, going forward in this module we will understand option pricing.

So, with these thoughts assume the trader decides to write (sell) the 18400 Put option and collect Rs.315 as the premium.  As usual let us observe the P&L behavior for a Put Option seller and make a few generalizations.

Do Note – when you write options (regardless of Calls or Puts) margins are blocked in your account. We have discussed this perspective here, request you to go through the same.

M5-Ch6-title

6.2 – P&L behavior for the put option seller

Please do remember the calculation of the intrinsic value of the option remains the same for both writing a put option as well as buying a put option. However the P&L calculation changes, which we will discuss shortly. We will assume various possible scenarios on the expiry date and figure out how the P&L behaves.

Serial No. Possible values of spot Premium Received Intrinsic Value (IV) P&L (Premium – IV)
01 16195 + 315 18400 – 16195 = 2205 315 – 2205 = – 1890
02 16510 + 315 18400 – 16510 = 1890 315 – 1890 = – 1575
03 16825 + 315 18400 – 16825 = 1575 315 – 1575 = – 1260
04 17140 + 315 18400 – 17140 = 1260 315 – 1260 = – 945
05 17455 + 315 18400 – 17455 = 945 315 – 945 = – 630
06 17770 + 315 18400 – 17770 = 630 315 – 630 = – 315
07 18085 + 315 18400 – 18085 = 315 315 – 315 = 0
08 18400 + 315 18400 – 18400 = 0 315 – 0 = + 315
09 18715 + 315 18400 – 18715 = 0 315 – 0 = + 315
10 19030 + 315 18400 – 19030 = 0 315 – 0 = + 315
11 19345 + 315 18400 – 19345 = 0 315 – 0 = + 315
12 19660 + 315 18400 – 19660 = 0 315 – 0 = + 315

I would assume by now you will be in a position to easily generalize the P&L behavior upon expiry, especially considering the fact that we have done the same for the last 3 chapters. The generalizations are as below (make sure you set your eyes on row 8 as it’s the strike price for this trade) –

  1. The objective behind selling a put option is to collect the premiums and benefit from the bullish outlook on market. Therefore as we can see, the profit stays flat at Rs.315 (premium collected) as long as the spot price stays above the strike price.
    1. Generalization 1 – Sellers of the Put Options are profitable as long as long as the spot price remains at or higher than the strike price. In other words sell a put option only when you are bullish about the underlying or when you believe that the underlying will no longer continue to fall.
  2. As the spot price goes below the strike price (18400) the position starts to make a loss. Clearly there is no cap on how much loss the seller can experience here and it can be theoretically be unlimited
    1. Generalization 2 – A put option seller can potentially experience an unlimited loss as and when the spot price goes lower than the strike price.

Here is a general formula using which you can calculate the P&L from writing a Put Option position. Do bear in mind this formula is applicable on positions held till expiry.

P&L = Premium Recieved – [Max (0, Strike Price – Spot Price)]

Let us pick 2 random values and evaluate if the formula works –

  • 16510
  • 19660

@16510 (spot below strike, position has to be loss making)

= 315 – Max (0, 18400 -16510)

= 315 – 1890

= – 1575

@19660 (spot above strike, position has to be profitable, restricted to premium paid)

= 315 – Max (0, 18400 – 19660)

= 315 – Max (0, -1260)

=  315

Clearly both the results match the expected outcome.

Further, the breakdown point for a Put Option seller can be defined as a point where the Put Option seller starts making a loss after giving away all the premium he has collected –

Breakdown point = Strike Price – Premium Received

For the Bank Nifty, the breakdown point would be

= 18400 – 315

= 18085

So as per this definition of the breakdown point, at 18085 the put option seller should neither make any money nor lose any money. Do note this also means at this stage, he would lose the entire Premium he has collected. To validate this, let us apply the P&L formula and calculate the P&L at the breakdown point –

= 315 – Max (0, 18400 – 18085)

= 315 – Max (0, 315)

= 315 – 315

=0

The result obtained in clearly in line with the expectation of the breakdown point.

6.3 – Put option seller’s Payoff

If we connect the P&L points (as seen in the table earlier) and develop a line chart, we should be able to observe the generalizations we have made on the Put option seller’s P&L. Please find below the same –

Image 3_Payoff

Here are a few things that you should appreciate from the chart above, remember 18400 is the strike price –

  1. The Put option seller experiences a loss only when the spot price goes below the strike price (18400 and lower)
  2. The loss is theoretically unlimited (therefore the risk)
  3. The Put Option seller will experience a profit (to the extent of premium received) as and when the spot price trades above the strike price
  4. The gains are restricted to the extent of premium received
  5. At the breakdown point (18085) the put option seller neither makes money nor losses money. However at this stage he gives up the entire premium he has received.
  6. You can observe that at the breakdown point, the P&L graph just starts to buckle down – from a positive territory to the neutral (no profit no loss) situation. It is only below this point the put option seller starts to lose money.

And with these points, hopefully you should have got the essence of Put Option selling. Over the last few chapters we have looked at both the call option and the put option from both the buyer and sellers perspective. In the next chapter we will quickly summarize the same and shift gear towards other essential concepts of Options.


Key takeaways from this chapter

  1. You sell a Put option when you are bullish on a stock or when you believe the stock price will no longer go down
  2. When you are bullish on the underlying you can either buy the call option or sell a put option. The decision depends on how attractive the premium is
  3. Option Premium pricing along with Option Greeks gives a sense of how attractive the premiums are
  4. The put option buyer and the seller have a symmetrically opposite P&L behaviour
  5. When you sell a put option you receive premium
  6. Selling a put option requires you to deposit margin
  7. When you sell a put option your profit is limited to the extent of the premium you receive and your loss can potentially be unlimited
  8. P&L = Premium received – Max [0, (Strike Price – Spot Price)]
  9. Breakdown point = Strike Price – Premium received

436 comments

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  1. khyati verdhan says:

    thanks kartik for your reply on my previous question and also for the next chapter!
    my question is
    Q-since options are traded on premiums. is margin is available on premiums. i want yo ask is suppose i have 1,00,000 rs. and nifty 8280 call option is trading at a premium of 100. then by this i can buy 1000 shares of nifty. but can i buy more than this. if yes it can be NRML, MIS OR BO&CO

    • Karthik Rangappa says:

      Yes, margin on options is possible as long you choose to execute it as a BO or a CO order. Will talk about it soon in this module.

  2. Vidhyalakshmi says:

    Hi Karthik. The Nifty closed today at 8181 and here are the prices (at EOD) of May Put Options with various strike prices:

    MayPut8200: 119 (IV=19; Premium = 100)
    MayPut8300: 162 (IV=119; Premium = 43)
    MayPut8400: 215 (IV=219; Premium = -4)
    MayPut8500: 282 (IV=319; Premium = -37)
    MayPut8600: 359 (IV=419; Premium = -60)
    MayPut8700: 443 (IV=519; Premium = -76)
    MayPut8800: 534 (IV=619; Premium = -85)
    MayPut8900: 628 (IV=719; Premium = -91)
    MayPut9000: 723 (IV=819; Premium = -96)
    MayPut9100: 825 (IV=919; Premium = -94)

    The higher the IV of the option, the lower goes the premium cost. In fact, after a point, the premium has a negative value. What’s the catch?

    MayPut9000 seems to have the highest padding…that is, if my view is bearish, I can have a tolerance of 96 points for the Nifty to go in the opposite direction, before I start to make a loss. Am I right? Are there any pitfalls in choosing this method?

    • Karthik Rangappa says:

      Well, if you notice as you traverse away from the strike price which are away from the current market price the difference crops up. This is mainly attributable to liquidity and moneyness of options. In fact in chapter 8 (will take it live in few days) I will discuss this.

      • Partha Kundu says:

        My question is what happens when I sell a put and it hit strike price. Do I have to buy it in cash? If I do trading in nifty and want to buy nifty at lower price is selling put a good strategy? Then I can own the nifty and renew it for next expiry for gain.

        • Karthik Rangappa says:

          No buying cash (at least as of now). All options are settled in Cash. What you are suggesting is sort of a covered all. You will be long and short at the same time. Returns are low, but the volatility in P&L is also low.

  3. Vidhyalakshmi says:

    The MayCall8200 Option costs 181 (IV=0; Premium 181). Why is the premium cost for the Call Option so much more than the Put Option for the same strike price? Is that because the Option Sellers expect the Nifty to go up? I’ve been told that, more often than not, the Option Sellers (usually the experts) are on the right side. So here, the Option Sellers have a bullish view?

    • Karthik Rangappa says:

      No, this has nothing to do with expecatations. Option premiums are dictated by 4 forces called the option greeks –

      1) Direction of market (Delta)
      2) Rate of change of market prices (Gamma)
      3) Volatility of the market (Vega)
      4) Time to expiry (Theta)

      These forces simultaneously acts on Option (real time) and hence the premium keeps varying. We will talk about these Option Greeks and try to simplify it as much as we can.

  4. iyengarnsv says:

    In the option put selling you have given formula P & L =Premium Paid-[Max(0,strike price-spot price)]. As I understand in option put selling we do not pay the premium, however, we receive the premium and pay the margin amount. So I think it should be premium received. Am I correct. Please clarify.

  5. keshav says:

    Sir, what is the in the money and out of the money in options?

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