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Disclaimer: Although most of the time writing or shorting puts often produces better results than buying calls or holding a stock it comes with its own inherent risk. Please know the risk involved before shorting a put. I am not responsible directly or indirectly for any ideas or strategies written in this post or this website.
Selling options whether it is call or put is considered very risky proposition especially by new and novice traders. One reason is everywhere it is written in option trading books as well as in many online websites that selling options is an unlimited risk. This is true on paper but is there any rule that says if you sell and option you cannot close it before expiry?
If selling options, you can always (just like buying options) – buy it back to close the trade. The risk is over when a trader buys back the sold option.
Another reason why new traders do not sell options is that they do not know that you can actually sell the option first. They think that you can only buy the option and then sell. Margin block is also an issue. Recently there was an increase in margin block rule which has also taken away lot of traders from selling options.
Do not forget that buying options also comes with its own risk. Buyer of an option is running against time. Time value of an option gets eroded with time if there is no movement.
How brokers take benefit of increase in margin block rule:
A trader goes to sell a put option and sees that the trade getting rejected due to new margin rule. Earlier he/she use dot sell option easily but now the order gets rejected. So he calls his broker. They say due to less margin rules it is not possible to sell an option. The trader asks so what to do? The broker advises the trader to buy call option. The trader is happy and buys the call option. Well what happens next is not important – but what I am trying to say is that DO NOT go by what your broker says. Trade what you want to trade. Brokers do this for brokerage – but it is you who makes the final decision.
Option trading is dangerous for traders who buy and sell options without any knowledge or as pure greed factor – treating them like a lottery.
The term – Buying options is unlimited profit is misunderstood and used like get rich fast scheme in option trading. Both the terms “Buying Options is Unlimited Profit” & “Selling Options is Unlimited Loss” are only good on paper. Reality is in both the trader is at risk – it all depends on how he manages his risk.
The truth is options were created to hedge (risk reducing investment) the portfolio of fund managers mainly equities – but retail traders use this to speculate and gamble. This is where options are misused.
This is the reason options should be traded with hedge. If you trade them without hedge you may suffer huge loss.
When Should You Sell Put?
When you see a stock trending up since a few days and you want go with the trend then you have three options as a derivative trader:
1) Buy stock future
2) Buy call option
3) Sell put option
Buying stock future is very risky as if the stock moves down 10 points from where you have taken the trade then you may stop out taking a loss.
Almost same with buying a call option – or you may choose to wait as the risk is limited. But it is well known that most options expire worthless.
So the better option is selling a put.
Whatever the case you should keep a stop loss.
In short even if the stock does not go up and stays there the put seller makes a profit however this is not the case with buyer of stock future or buyer of call option.
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