Options PnL Part 2

So, we looked at buying calls and buying puts. Respectively, the graphs look like:

1-pnl2

The blue graph is buying a call option with the strike price of 15 for a price of 2 (kink is at 15 and the most we can lose is 2). The orange graph is buying a put option with the strike price of 35 for a price of 3 (kink is at 35 and the most we can lose is 3). We can also say (more simply) the graph on the left is for the 15 call for a price of 2 and the graph on the right is for the 35 put for a price of 3.

Let's take a look at selling calls and selling puts. I'll go into detail about selling puts (in my experience, this topic gives most people a hard time). Using the same put from above for this example (strike price of 35, the price of the contract being 3), let's say you are selling an option that gives the buyer the right to sell (to you) the underlying at the price of 35. What do you get in return for selling this right? 3! So, you collect 3 and you'll keep it if the price of the underlying , at expiration, is greater than or equal to 35 (since the holder of the put won't want to sell it to you at 35 when he can just go to the marketplace and sell it to someone else for more money). For any price under 35, he has the right to sell it to you at 35. For instance, if the underlying is valued at 28 at the time of expiration, then the holder might exercise his right and sell (to you) the underlying at the price of 35. That is to say, you have purchase the underlying from him for the price of 35 (even though you could buy it at the marketplace for 28). So, our graph will look a lot like the orange graph above, just flipped.

2-pnl2

Okay. Now using the same logic for selling a call, we have the following graph:

3-pnl2

In selling the put, the best case scenario is you collect 3. That is. There isn't anything better than that. The worst case, however, is when the underlying price goes to zero. You will be forced to buy the underlying (now worthless) for the strike price (35). So, the most you can lose is 35. Or, more generally, the strike price.

In selling the call, the best case scenario is your collecting 2. The worst case scenario happens when the underlying value goes up towards infinity. In that case, our losing is potentially infinite.

This is why most brokerage firms (Schwab, ETrade, Fidelity, etc.) won't let you sell options without making a very large deposit (called a margin) for those worst case scenarios.