Thursday, December 15, 2011

misleading PnL graph - short option positions

PnL graph of short option position is misleading. Both call/put show a inverted hockey stick indicating huge potential loss when price move against option writer -- when writer gets assigned (at or before expiration). Let's assume the writer wrote an OTM call/put, earning the premium.

Reality is, many option writers don't mind assignment.

A long term bull writes an OTM put, below spot, and doesn't mind buying at that slightly[1] low price, because she wants to buy it anyway and now she gets to buy it at a better/lower price! If you are long term bullish then you want to buy it anyway, so now you just need to hold it for a while. PnL graph shows a huge paper loss, but a long term bull won't liquidate and realize the paper loss. So the PnL graph is misleading.

[1] Usually an OTM put is slightly below spot. Most positions and trades are concentrated near ATM.


------------ That's PUT. Now calls ---------------------

A long term bear writes an OTM call (like a "get a beer for $99 with this coupon"), above spot ($88), and doesn't mind selling $99, unless she is forced to buy it from open market at a sky high price. This unlucky scenario is uncommon because --
* PnL graph shows a huge loss assuming writer has to buy from open market, but many (if not most) OTM call writers are buy-writers, so they already hold the asset. If they end up selling at $99, they don't lose. Remember spot at the time of option sale is $88, so they sold a good price.
* stocks are less likely to rise sharply than drop sharply.

Also, a long term bear wants to sell the stock anyway. Now she gets to sell good price.

Lastly, don't forget the premium income.

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