Risk and Reward Characteristics of Selling a Put Option
An
example of the profit and loss potential
in the present and at expiration of selling an
April 100 put for $5. The profit potential Is
limited, but the loss potential is not limited
and similar to being long the future at 95. The
most the put seller can make is $5 but the loss
is limited to the future dropping to 0, but
still much greater than the potential gain.
The three scenarios at expiration are:
-
When the future is
above 100, the put seller will probably not be
assigned the future; so a profit of $5 will be made
from the premium received in selling the put.
-
If the future is
at 100, assignment may occur which would make the
put seller long at 100. The future can be sold at
100 in the open market to
scratch the long position. The put seller will still
make $5 from the premium received in selling the
put.
-
If the future is
at 95, the put seller will be assigned and long the
future at 100. Selling the future in the market at
95 will incur a loss of $5 ($95 - $100 = -$5) but this will be
negated by the $5 premium received from selling the
put for a breakeven trade. Below 95 the put seller
will lose just as much as if being long the future
at 95.
The put writer will make a profit as long as the future is above 95 at
expiration, but may begin to lose substantial
amounts if the market drops precipitously. The price
of the put exhibits the same sensitivity to a price
change in the future as described previously.
Many people find
selling options unsettling because of the limited
profit opportunity and unlimited loss potential. Why
risk so much to make so little? The same people find
purchasing options attractive for the same reasons.
Why not risk a little to make a lot? There are very
good reasons to buy and sell options. When markets
become less volatile option writers will probably
achieve better results than option buyers. When
markets become more volatile, option buyers will
probably do better than option writers. There is a
time to buy and a time to sell options, just as in
outright position trading, where it is better to go
long in a bull market and short in a bear market.
The option writer can generally do better than the option buyer in dull
or congested markets, which may occur more often
than strongly trending markets. For example, the put
buyer and seller will profit in the previous
examples if the market remains between 95 and 105,
whereas the option buyer may lose money.
When buying or selling options the trader must be concerned with the
fair value or proper price of the option. There are
many ways to evaluate the price of an option by
using option valuation models.
Virtually any other
strategy such as a straddle, lime spread, or
butterfly are simply combinations of these graphs.
To summarize, the six possibilities are:
-
Buying the
outright
-
Selling the
outright
-
Buying the call
-
Buying the put
-
Selling the call
-
Selling the put
Risk and Reward Characteristics
of Selling a Put Option
