Put writing is an options trading strategy that is usually used by traders who have a little experience with making stock market predictions. Traders intending to use put writing as part of their trading strategy will usually have the ability to watch the market and predict which way it will move. Moreover, put writing is usually used in combination with other options trading strategies.
In this article, we will explain put writing in a manner that can help traders in the early phase of their trading journey to understand how it works so that they can work towards developing the necessary market skills and knowledge to start using it. But first, let’s find out what put writing means.
What is put writing?
Put writing means selling a contract wherein you agree to buy stocks at a price mentioned in the contract (known as the strike price), by a certain date mentioned in the contract (known as the expiry date). The trader also earns a small amount (known as the premium) for opening a position or for putting a put contract on the market. Writing a put contract essentially means selling a put contract.
You will usually write a put when you expect the market prices of shares to either rise or stay where they are. In other words, put writing is a bullish trading strategy.
How does put writing work?
Let’s explore some of the methods that a trader may use put writing to target potential earnings on the stock market.
Earning from the premium
Put writing may be very simply undertaken to target earnings from fluctuations in the premium prices of the put options contracts. For example, if Mohini writes a put options contract wherein she agrees to buy 100 shares at a strike price of Rs 100 by the expiration date. The market share prices are Rs 110. She pays a premium of Rs 2, which amounts to Rs 200 when multiplied by the number of shares. So far, Mohini has earned Rs 200 and has invested nothing.
Mohini has no intention of buying any shares. She simply intends to benefit from a rise in the price of the options contracts.
As the expiration date approaches, Mohini is pleased to note that as per her predictions, the stock price has remained hovering around the Rs 110 level. The contract buyer has no good reason to sell shares to Mohini for Rs 100 when they could sell it on the open market for a higher price.
Mohini has earned from the premium as per her investing strategy.
Earning from the “great deal”
Put writing may also be undertaken as a means to reduce one’s entry price. Let us take the example of Jai, who writes a put contract where he agrees to buy 100 shares at Rs 70 by the expiration date. The market prices on the day of Jai buying the contract are Rs 75. Jai earns a premium of Rs 2, which totals to Rs 200.
Jai is keen to get the shares at a price that is lower than the market price, or else he hopes to break even. Jai predicts that the market will rise. In fact, he feels like prices will soon hit Rs 80, maybe even Rs 90. He will be entering at potentially profitable entry price if he manages to buy shares at Rs 70 in such a scenario, because he might be able to sell his shares, as soon as he gets them, and earn Rs 10 to Rs 20 per share.
Two scenarios could actually work out for Jai
Scenario 1: When the expiration date arrives, share price is Rs 70. The contract is exercised and Jai gets the shares at the same price as the market price, but he has also earned Rs 2 per share additionally. If the share prices rise quickly after this as predicted by Jai, he might be able to sell at a higher price and walk away with earnings.
Scenario 2: As the expiration date approaches, the share price is Rs 69 and the but the buyer
Jai has to pay Rs 1 per share more than the market price. Sounds like a loss? But wait, Jai has also earned Rs 2 per share on the premium. So as it turns out, Jai still walks away with earnings of Rs 1 per share. Besides, the share prices might still rise as predicted by Jai and he still stands to earn on the sale.
The happy examples above depict how things would play out if things went in the trader’s favor. But what if things did not? What does that look like?
In either case, the stock price could tumble terribly and the put writers would be left paying the high strike price when in fact the stock price has fallen (and might even continue to fall if the traders have invested in a stock with an inflated price, or if they picked a failing company).
Alternatively, they could end up getting the stock at the desired stock price, but the stock could continue to fall. In this case they are holding a potentially loss-making stock. This means that their prediction has been incorrect, because the stock price is falling instead of rising.
Limiting one’s losses
Either Mohini or Jai could, however, when they witness stock prices tumbling below the strike price go ahead and write a call option. This is the reverse of a put option in the sense that one agrees to sell shares at the strike price by the expiration date. They might have to spend a higher premium on such a contract because it will be in demand (who wouldn’t want a contract that allows them to sell at a price higher than the market price?). However, they can pay the premium, limit their losses and exit the trade.
Writing put options does offer minimal earnings gaurantee because of the premium amount earned. However, the risk is unlimited because the stock price can fall far below the strike price. It is therefore important for traders to have an exit strategy in hand or to use put options in tandem with other strategies that help them minimize their risk.