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This is a level 2 question.
I am having a hard time understanding that if I own stock of XYZ how can I write puts to make money and how exactly does this compare to writing calls. I understand a little of the concept of writing calls.
An excellent question that a lot of us could use as a refresher on why we write certain options when we do. First, let's get some of the terminology cleared up. When you write an option, you are selling an option to someone. An option such as a call gives the option buyer the right but not the obligation to buy stock at the strike price. Meanwhile, a put option gives the option buyer the right but not the obligation to sell stock at the strike price. Therefore, when you sell a call option to someone, you are giving them the right to buy stock from you. This is just the opposite of when you sell a put. When you sell a put, you give someone else the right to sell stock to you. Therefore, you actually buy stock when it is "put to you." Remembering this will keep you from getting confused especially when combining puts and option selling together. Finally, the part about "not having the obligation" just means that if the buyer of the option doesn't want to go ahead and buy the stock in the case of a call or sell stock in the case of put, they don't have to if they don't want. They are under no legal contract to do so if they choose not to. They can't be forced to complete the trade. It's not like a regular stock trade in which the buyer could be forced to pay funds and the seller forced to deliver stock. However, the option buyer does have to pay the premium to the seller of the option, which is usually just a small fraction of the total stock's value.
A Reactive Versus Proactive Options
Let's briefly discuss buying an option versus selling an option. It all boils down to a proactive versus a reactive stance and which are you more comfortable with. When you buy an option, you take on a proactive role in managing those options. As a buyer of an option, you make money only if the stock goes in your direction. In addition, your unlimited profit potential is dependent on your skill and ability to analyze the situation and ride the trend as long as there is one. Therefore, you must constantly watch and analyze the market. Furthermore, the buyer of the option can determine if he wants to exercise the option or not, when he wants to exercise the option, and how much profit he wants to hold out for.
On the other hand, an option seller is reactive. The seller profits as long as the market stays away from the direction of the option that he shorted. Although the seller watches and analyzes the market, he does his best by sitting on his hands and doing nothing. This is because his profit potential is already predetermined. He can't make any more, but he can cut into those potential profits if he reacts too quickly to an adverse piece of news. On the other hand, he can also lose an untold amount if he reacts incorrectly by hesitating to get out of a losing position or holding on to long to a loser and hoping for a reversal.
The seller of an option reacts to the buyer's exercise and then takes action afterwards. The seller also is limited to the amount of profit that can be made but their losses are uncapped. In theory, an option seller should always try and capture that maximum profit amount by doing the least amount of work and only jettison the position when the trend reverses course and looks like it will go through the strike price.
Buying versus Selling
Buying an option is done best when you have strong feeling on the direction and think volatility could rise. In that way, you benefit from both option forces. It is also a good idea to buy an option when you want to limit your loss yet still maintain a presence in a market, especially when markets are choppy but likely to trend soon, possibly after an announcement.
Selling an option is best when volatility is high and you can eliminate only one of three trading conditions. You know it won't rise but you aren't sure if the market will fall or just sit; therefore you sell a call. In the case of a call, the upside is literally unbounded. Takeovers can lead to stratospheric levels while puts are theoretically bounded by zero. Nevertheless, shorting puts can be disastrous if the quantity amount is larger than what a person can financially handle.
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Question Level Key
Level One--Basic Jargon, Definitions, Basic Mechanics of Trading.
Level Two--Introductory Points, Practical Points and Simple Strategies
Level Three--More Advanced Strategies and Repairs
Level Four--Risk Management, Psychology, and How Best to Evaluate Things.
Level Five--High end questions concerning Portfolio Analysis, Managing a Portfolio
of Options, Option Pricing Models, and Nuances of Trading. Included could be a variety of
other topics.
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The key component to this equation is that we need your questions. They can be as
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