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Options trading opens the doorway to complex income strategies like put writing. What if you could collect premiums even when markets move sideways? Put writing makes it possible, though obligations are there.
Put writing might be an excellent upgrade to your trading strategy once you get comfortable with the concept of it. Here’s how!
What is put writing?
The term “put writing” means that when you are selling a contract, it requires you to purchase the underlying stock at the strike price, assuming the contract is exercised by the buyer. Here, “writing” refers to the process of opening a position after the sale of a put contract. This needs to take place before the specified expiry date.
With this strategy, you instantly make a profit when you sell the put option and get a premium or fee.
That said, you will have to purchase the shares if the value of the underlying stock drops below the strike price. Put writing is essentially a bet on the stock price to either climb or stay stable, which allows you to retain the premium without actually purchasing the shares.
Differences between call and put writing
Call writing is the act of selling call options, which bind the seller to sell a commodity at a certain price. Following are the ways they differ from each other:
|Selling a call option contract that gives the buyer the right to purchase the underlying asset at a specific price within the expiry date
|Selling a put option contract that enables the buyer to sell the underlying asset at a specific price within the expiry date
|To deliver the underlying asset at a specific price if the option is exercised by the buyer
|To obtain the underlying asset at a specific price if the option is exercised by the buyer
|Bearish or neutral
|Bullish or neutral
|Unlimited, as the underlying asset can rise indefinitely, resulting in a loss for the call writer
|Limited to the strike price minus the premium received, as the underlying asset can fall to zero, resulting in a loss for the put writer
|To make profits from a stable or moderately declining market
|To generate income from a stagnant or moderately rising market
Pros and cons of put writing
- Generating revenue: Invest in steadily growing markets to get premium income.
- Boosting your portfolio: Even in moderately favourable markets, you could enhance your portfolio’s profits by investing in option premiums.
- Hedging instrument: To hedge against potential losses, consider selling put options on your current assets.
- Flexibility: Use with a wide range of investment goals and underlying assets.
- Obligation to buy: By purchasing the underlying asset for more than its market worth, you may suffer losses.
- Capital requirements and margin: You must have sufficient funds or margin to sell put options.
- Market risk: If the underlying asset’s value drops significantly, you lose revenue.
Put writing strategies to follow
There are two different strategies among others to write puts, even though they may sound similar: cash-covered put writing and covered put writing.
Cash-covered put writing:
A cash-covered put is an approach in which you simultaneously put aside the funds you need to buy the underlying stock at the option’s strike price and sell an OTM put option.
When you write a cash-covered put, you set aside the money you need to purchase the underlying asset at the strike price. If you write a cash-covered put, you can be bullish or neutral. The goal is to make money from the option prices and maybe get the underlying asset for a lower price.
A covered-put approach involves a short put option and a short stock option. This options strategy has low-profit potential and unlimited risk.
Covered-put writing is a neutral or bearish technique that tries to make money when the value of the underlying object goes gradually lower or stays in a narrow range. When you write a covered put, you sell the underlying asset short and write a put option on it.
However, keep in mind that both approaches need careful consideration and risk management due to their high levels of volatility.
Apart from these two strategies, other put writing methods may include: short put, short put synthetic, long/short put condor, short put ladder, short put butterfly, and other complex ones.
With careful analysis and risk management, put writing offers flexibility to meet diverse investment goals. Though obligations exist, this income generation tool holds appeal for moderately bullish to neutral markets when you strategise it properly.
Option writing can be a profitable strategy if done correctly. Option writers receive premiums upfront and hope that the options expire worthless or decrease in value. However, option writing also involves unlimited risk and limited reward potential.
Both puts and calls have similar risk profiles, depending on whether they are bought or sold. Buying puts or calls has limited risk and unlimited reward potential, while selling puts or calls has unlimited risk and limited reward potential.
Put options are written by investors who have a bullish or neutral outlook on the underlying asset and expect its price to stay above or close to the strike price. Put writers aim to generate income from premiums and potentially acquire the underlying asset at a lower price.
One of the safest option trades is the covered call, which involves owning the underlying asset and selling a call option on it. This strategy limits the upside potential but also reduces the downside risk. The covered call can provide income and protection in a flat or moderately declining market.
Options are not gambling but a form of financial derivatives that can be used for various purposes, such as hedging, speculation, income generation, and portfolio diversification. However, options trading involves high risk and requires knowledge and discipline.