Every option trade has a buyer and a seller. Selling an option is also sometimes referred to as writing an option. So far we have focused on put options from the buyers side, but it’s also important to understand the transaction from the sellers point of view.
Apart from any trading fees, an option contract is a zero sum game. Any profit made by a put option buyer will result in an equal loss made by the put option seller. Conversely any loss made by a put option buyer will result in an equal profit made by the put option seller.
This relationship means the profit/loss chart for the put option seller is similar to the profit/loss chart for the put option buyer, but flipped along the x-axis. Here we can see the same put option we looked at in the previous lecture, with a strike price of $100, and a premium of $5 per share.
The profit/loss of the put option buyer is shown in blue, and in red we can see the profit/loss of the put option seller. At each level of underlying price, the PNL lines for buyer and seller are an equal distance away from the x-axis, but on opposite sides of course, one positive and one negative.
Where both lines cross the x-axis represents the breakeven point, i.e. the point at which $0 profit or loss is made. The buyer and seller of the option share the same breakeven point as well (again, this is ignoring any trading fees).
When the underlying price is above the strike price at expiry, you will remember the put option buyer has a fixed risk. For the put option seller, this means they have a fixed profit when the underlying price is above the strike price at expiry.
The seller has a cap on their profit, and that is the premium they collected for the option. In this case $5 per share for a total of $500. No matter how high the price moves, the seller can make $500 at most.
(Almost) unlimited risk
When the underlying price decreases below the strike price, the potential profit for the put option buyer is limited only by the share price reaching zero. This means the potential loss for the put option seller is also only limited by the share price reaching zero.
This is a key point because, even though there is technically a cap, it means the put option seller can still lose far more than they collected in premium, and even potentially lose everything in their trading account. For this reason it is extremely important for new traders to make themselves fully aware of the risks before selling options.
The effect of time
As the put option seller’s potential profit is capped to the premium collected, but their potential loss is limited only by price hitting zero, you may be asking yourself why a trader would choose to sell a put option in the first place.
Remember from the previous lecture that there is an inherent time limit on an option. For the buyer of the put option this represents a need for the underlying price to decrease sufficiently before the expiry date. So time is against the buyer.
For the seller though, the passage of time helps them. Every day that passes, the option will lose a little bit of it’s value. The more time that passes without the underlying price decreasing, the more value the option will lose, and the more profit the put option seller will be making.
Put another way, if the price moves down this is bad for the put option seller, however if the price moves up or if the price does not move at all, then this is good for the put option seller. So if nothing happens, the seller is benefiting.
When buying an option, this will normally require the buyer to pay the entire premium up front to open the position. As the maximum the long put option can lose is the premium paid, this is the only capital the buyer needs to use.
In contrast the maximum loss for selling a put option is the strike price minus the premium collected, a figure that will be considerably larger. The seller may not be required to hold enough in their trading account to cover their maximum loss, but they will be asked to keep a certain amount in their trading account to support the position. This amount is called margin. Margin is an amount the broker has deemed appropriate for the trader to keep in their account to support their positions.
As the losses of selling a put could exceed this amount if the price decreases significantly enough, this could leave the seller in a position where they need to add more funds to their trading account, or face having the position forcibly closed by their broker at a loss.
Once you’re experienced with options, the margin system of the trading platform you are using will be second nature to you. However, this added complexity and risk means it is advisable to stick to buying options, or at least avoid selling naked options when you’re first starting out. That is until you’re comfortable with how the margin system works and what risk is involved with selling options.
Selling a naked option means you have sold the option with no other position covering it at all. In other words there is nothing else in your account hedging that undefined risk.
It is possible to turn a short option position into a risk defined position by adding a long option to the position, converting it to a vertical spread. We will cover this later in the course.
Selling a put option is the complete opposite of buying a put option. Both the risk and reward are reversed. Any profit for the seller is a loss for the buyer, and vice versa.
Buying a put is a bet that the underlying price will decrease, and selling a put therefore is a bet that the underlying price will not decrease. Or at least not decrease beyond the strike price.
The seller of a put option has a limited profit potential. Their maximum profit is the premium they collected for the put.
The seller also has a risk only limited by the asset reaching a price of zero, meaning they could lose far more than they initially collected if the price decreases significantly. As they have undefined risk they will also need to be aware of the margin system of the site they are using.
When you’re brand new to options, it’s best to wait until you’re confident you have sufficient knowledge of the risks before selling naked options.