A trader who thinks a stock might dip before moving higher has a variety of choices when deciding what type of order to place. Each choice has risks. Two of the easier-to-execute orders are a limit order and selling a put option (also known as "writing a put"). Both of these choices allow the trader to buy an investment on weakness. Both can miss-out on upside potential and both can lose the full value of the investment if the business goes bankrupt. That's where the similarities end.
A trader places a limit order to buy by entering a buy order with a limit to how much he is willing to pay for the stock, typically below the current trading price. If the stock drops to the limit price, the buy order is triggered at the limited price. These are good orders to use in markets that tend to have bounces throughout the day or week and can allow a trader to open a position at a lower price on the next dip. Traders who use limit orders risk not opening the position if the stock does not dip. If the stock doesn't move to the limit price, a trader could miss out on all gains.
A trader could sell a put option to mitigate part of this upside risk, but different risks emerge. By writing a put, a trader is selling someone else the right (aka option) to force (assign) the writer to buy the stock at an agreed upon price (aka strike). The writer receives a premium (cash payment up front) for giving up this right. The writer gets to keep the premium if she is or is not assigned the underlying stock. If the stock drops and the shares are assigned, the writer has bought the stock at a discount, just as the trader did who placed a limit order. If the stock does not drop enough to trigger an assignment, the put writer still makes some profit from the premium and does not completely miss the opportunity. The discount from the starting price can be much bigger using a put than a basic limit order due to the premium received. (The amount of discount depends on multiple variables that could lead to a full discussion on how options are priced.)
A put seller risks missing most of the gains if the stock reverses after dipping and rallies much higher. Unlike a limit order that is triggered below the limit price, a stock is not necessarily assigned if it dips below the put option's strike. Option assignments tend to happen on the last day of the option contract before it expires or if the stock falls far below the strike. A put seller operates with more "singles" than "home runs" since the upside potential can be limited if the timing doesn't work out. For some investors, the benefit of not missing out completely on profits via the premium received up front and the reduced downside risk outweigh the benefits of an occasional stock that rallies more than expected. These are the investors who should sell options.
An investor not concerned with buying at a cheaper price can eliminate the upside risk by buying the shares with a market order at the current trading price. Buying put options or call options are other methods to help reduce downside risk and leave open the upside potential, but that's for another post.
For simplicity, I used the term "stock" in this explanation, but most ETFs can be bought using both of these methods. A trader can also use a limit order when writing a put just as easily as using a limit order to buy a stock. Using a limit order when selling a put option can give a bigger buffer before the trade turns into a loss, but can also increase the upside risk.
If you liked this article, here are two more on related topics: Are Stock Options Risky? and Understanding Risks in Investing.
