Derivatives Trading Basics
by 5paisa Research Team Last Updated: 2023-07-20T17:48:43+05:30
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Let's unravel the world of trading strategies, starting with 'Put Writing.' Imagine having a secret weapon that allows you to make money or buy your favourite stocks at a cheaper price. That's what put writing offers! It's a method used by skilled traders that's all about balance and timing. While it might seem a bit complex at first, don't worry. Once you get the hang of it, put writing could be a great addition to your trading plan. In this introduction, we'll help you understand the basics of put writing and how you can use it to your advantage.

What Is Put Writing?

Put writing, an integral part of options trading involves selling a put option to open a position. In simpler terms, when you write a put, you're selling a contract that obligates you to buy an underlying stock at a specified strike price, if the contract is exercised by the buyer. This must occur before a predetermined expiration date. The appeal? You receive a premium or fee for selling the put option, turning a profit straight away. However, the crux lies in the fact that if the underlying stock price plunges below the strike price, you're on the hook to buy the stock. In essence, put writing is a wager that the stock price will stay steady or rise, allowing you to keep the premium without having to buy the stock.

Put Writing for Income

In trading circles, one of the strategies that savvy traders often employ is called "put writing." It's a strategy involving the selling of a contract, also known as a put option. In this scenario, you, as the seller or put writer, agree to purchase a specific quantity of stock at a predetermined price, known as the "strike price," within a certain period.

Let's assume you're tracking a stock currently priced at ₹1,000 per share. As a put writer, you sell a put option with a strike price of ₹950, collecting a premium of ₹50 per share upfront. If the stock's price remains above ₹950 until the option's expiry date, the buyer will not exercise the option. Consequently, you retain the ₹50 premium as your profit.

However, caution is advised. If the stock price falls below ₹950, the option buyer may exercise their right. You, as the put writer, must then purchase the stock at the strike price, regardless of its lower market price. The inherent risk in put writing is thus offset by strategic decision-making, a keen understanding of market trends, and the income from the premiums collected.

Writing Puts to Buy Stock

Put writing can be employed as a strategic approach to acquiring stocks at a lower price. Imagine you're interested in a certain stock presently priced at ₹1,800 per share. You think this stock is overvalued and would make a good buy at ₹1,600. In this case, you can write a put option with a strike price of ₹1,600, indicating your willing purchase price.

If the market price never falls to ₹1,600 or below before the expiry, the option will go unexercised. You will then keep the premium you collected initially. This is your income from the trade.

Conversely, if the stock price drops to or below ₹1,600, the option buyer may exercise their right, and you must buy the stock at the strike price. This might seem risky, but it provides you with the opportunity to buy your chosen stock at a lower cost, and the premium you collected further decreases your net cost. It's a method that demands careful market analysis and risk tolerance but can be profitable if applied wisely.
 

Closing a Put Trade

Closing a put trade, or "buy-to-close," occurs when the original seller of the put option repurchases the same contract to effectively cancel out the obligation set when the option was sold. For instance, let's say you wrote a put at ₹800, earning a premium of ₹30. However, due to a sudden market shift, you wish to exit your position early. If the current market price of the option is ₹20, you can buy the same put option to close the trade. Although you lose ₹20, your net income is still ₹10 (₹30-₹20). This strategy is frequently employed to either lock in profits or prevent additional losses, hence providing the put writer with greater control over risk.

The flipside

Like every trading strategy, put writing also has a flipside. Primarily, the maximum profit from a put write strategy is limited to the premium received when selling the put. However, potential losses can be substantial. Should the price of the underlying stock plummet far below the strike price, the put writer is obligated to purchase the shares at the significantly higher strike price, resulting in a sizable loss.

Let's say you sell a put option with a strike price of ₹1200, and the stock price plummets to ₹800. You are obliged to purchase shares at ₹1200 each, despite the fact they are now worth ₹800. Your loss, therefore, is the difference, i.e., ₹400 per share, partially offset by the premium collected initially.

Furthermore, put writing demands keen market understanding and trend prediction. The risk of misjudgment is inherent in this strategy. Therefore, it's recommended that investors approach put writing with careful consideration, sound analysis, and an informed risk management strategy. The potential rewards of put writing can be significant, but the associated risks necessitate a thoughtful and well-planned approach.
 

Put Writing Example

Let's take an example. Suppose shares of XYZ Ltd. are currently trading at ₹1000 per share. An investor, Ravi, is neutral to slightly bullish on XYZ. He sells a put option for XYZ with a strike price of ₹950, which expires in a month and receives a premium of ₹50 per share (₹5000 for the contract of 100 shares). Ravi's hope is that XYZ's price will remain above ₹950 until the expiry. If the price stays above ₹950, the put option will expire worthless, and Ravi will keep the ₹5000 premium. If the price falls below ₹950, he'll be obliged to purchase the shares at ₹950 each, but his effective cost will be ₹900 per share due to the premium received.

 

Conclusion

If you're new to options trading, understanding the "put writing meaning" can give you a strategic advantage; it's essentially a way for a trader to earn premium fees while potentially acquiring a desired asset below its current market value. However, it is not without risks. Put writers may face substantial losses if the underlying stock price dramatically declines. Therefore, it's crucial to approach this strategy with an informed mind, having done thorough research and analysis. For those who can properly manage the associated risks, put writing can be a profitable addition to their trading repertoire.

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Frequently Asked Questions

Writing a put option involves selling a put contract on the market. For example, if you believe the stock price of a particular company is likely to rise or stay steady, you can write a put option on that stock. Firstly, you would need to decide on the strike price, which is the price at which you agree to buy the underlying stock. The expiration date is another factor to consider, as it defines the contract's lifespan. Once these parameters are set, you sell the contract in the options market, receiving a premium upfront from the buyer. The premium represents income that you keep, regardless of what happens with the stock price. However, remember that as a put writer, you must purchase the stock if it falls below the strike price, up until the option's expiration.

You would typically write a put option when you have a neutral to bullish outlook on a stock. This is because the primary goal of put writing is to collect the premium, which happens if the stock price stays above the strike price until expiration. If the price falls below the strike price, you would be obligated to buy the stock. Therefore, a put writer hopes that the underlying stock's price will remain steady or increase.

When you sell a put option, a few outcomes are possible. If the price of the underlying stock remains above the strike price until expiration, the option will expire worthless, and you keep the premium received at the outset. However, if the stock price falls below the strike price, you will be obliged to buy the stock at the strike price, which could result in a loss. This loss can be offset somewhat by the premium you received when selling the option. It's important to note that the risk in put writing is substantial as you're liable to purchase the shares even if their price dramatically drops.