“Buying options allows you to take part in big moves with limited risk.”
“Eighty percent of options expire worthless.”
“Volatility is the single most important factor for any option trader.”
“If you sell an option and it moves against you, you are stuck until it expires.”
In the debate between buyers and sellers of options, opinions get represented as fact and fact gets distorted into misconception. So it may be helpful to clear up some of the more common facts, myths, and misconceptions about buying and selling options. It should also settle the argument once and for all about which side of the option buy/sell equation an investor may want to understand first.
1
The standard definition of an option is the right, but not the obligation, to buy or sell a particular stock or commodity at a specified price. A call option is the right to buy. A put option is the right to sell.
When a trader buys an option, he is buying the right to buy or sell at a specified price. When a trader sells an option, he is selling the buyer that right and assuming the obligation to take the other side of the market should the buyer exercise the option.
That is the simple definition. The practical difference is where the real education begins.
2
Most traders first learn options from the buying side. Buy a call if you are bullish. Buy a put if you are bearish. The most you can lose is the premium paid for the option. The potential for a large gain is what attracts many traders to option buying in the first place.
But there is a hard lesson in option buying: time decay.
If you buy an option, the underlying market can move in the right direction and the option can still lose value if the move is not sharp enough or fast enough. All other things being the same, time decay will erode the value of the option with each day that passes. Even if an investor is correct in his market analysis, time will always be the enemy as long as he is buying options.
That is the part many novice option traders miss.
3
The value of an option is made up of intrinsic value, time value, and volatility.
An option is said to have intrinsic value if it is in the money. If it is not in the money, it cannot, by definition, have any intrinsic value. This is why many out-of-the-money options are made up entirely of time value and volatility. If the market does not move beyond the strike price by expiration, the option may expire worthless.
The main drawback to the option buyer is this: although the risk is limited to the premium paid, there is a high probability the buyer may lose on the trade. The only way the buyer generally makes money is if the underlying contract makes a sharp and immediate move in the correct direction. Anything less, and time value eventually decays away.
To sum up the buy side: the key advantages of buying an option are absolute limited risk and the potential for a large gain. The disadvantages are just as important. Time works against the buyer, and there is only one way to profit: the market must make a substantial move, in the right direction, in a short period of time.
4
The terms buying and selling, when used in relation to options, describe which side of an option trade a trader is positioned. When a trader buys an option, he is buying the right to buy or sell at a specified price. When a trader sells an option, he is selling the buyer that right. This is why option selling is also known as option granting or option writing.
In options, there must be a buyer for every seller and a seller for every buyer. However, this does not mean that if you are holding an open option position, you must buy or sell your option back to the same individual who bought it from you or sold it to you. You simply buy or sell the option back in the open market to close the position.
Many new investors also make the mistake of believing that buying options is bullish and selling options is bearish. This is a mistake. Buying a call is bullish. Buying a put is bearish. Selling a put is bullish. Selling a call is bearish.
Buying isn’t always bullish. Selling isn’t always bearish.
Buying a Call
Bullish
Buying a Put
Bearish
Selling a Put
Bullish
Selling a Call
Bearish
5
If a trader sells a put option, he is generally taking a bullish position. He is collecting premium based on the belief that the market will remain above a certain price level through expiration.
If a trader sells a call option, he is generally taking a bearish position. He is collecting premium based on the belief that the market will remain below a certain price level through expiration.
The appeal is clear. By selling an option, the premium is credited to the account immediately. If the market does not reach the strike price, the option can expire worthless and the seller may retain the premium.
But the seller does have risk.
If the market moves through the strike price, losses can occur and margin requirements may increase. The seller may choose to liquidate the option, accept a loss, add additional capital, or adjust the position according to his risk plan.
This is why a seller wants to select an option with low delta, enough time decay, and enough volatility that the market can move a long way without greatly affecting the price or margin requirement of the option. A market move large enough to stop out a futures trader may mean only a minor price adjustment to the option seller.
Risk Reminder: Trading futures and options on futures involves substantial risk of loss and is not suitable for all investors. Certain option-writing strategies, particularly uncovered positions, may involve substantial or potentially unlimited losses. Adverse market movements may also result in increased margin requirements and the need to deposit additional funds. OptionSpreaders.com utilizes spread-based strategies intended to offset or limit certain risks, but spreads do not eliminate the possibility of substantial loss. Investors should carefully consider whether these strategies are appropriate in light of their financial condition, investment objectives and ability to bear risk. Past performance is not necessarily indicative of future results.
6
Of course, an option seller does not have to hold the option through expiration. This is one of the most common misconceptions.
An option seller may elect to liquidate the position at any time prior to expiration simply by buying back the option at the going market price. This could result in a loss or a profit. However, the seller controls it.
If the position becomes uncomfortable, if market fundamentals change, or if the risk is no longer worth the premium remaining, the seller can pull the plug on the trade and move on.
That is how risk is handled in option selling.
7
One of the three main factors affecting the value of an option is volatility. Volatility measures how fast and how much the option value is moving in relation to the underlying market. Markets making large moves, or experiencing large or rapid daily price fluctuations, will generally produce options with higher volatility and higher prices. Slow or quiet markets generally produce lower-valued options.
If volatility is high, conditions may favor option sellers because they can get more premium for the options they want to sell. If volatility is low, it may favor option buyers because they pay less to purchase their options.
This does not mean an investor should sell options just because volatility is high. A high-volatility option may still be a poor option to sell. A low-volatility option may also be a poor option to sell. Volatility is important, but it is not the only consideration.
In our opinion, if you can use a little knowledge and a lot of common sense simply to pick a price level of where the market will not go, volatility becomes less important.
8
Making money selling options does not require a trader to pick the exact market direction. In many cases, the seller is attempting to pick a price level the market is unlikely to reach before expiration.
That is a very different kind of trade.
Selling options goes against a genetically programmed human trait. It is counterintuitive. The majority will resist it when you try to explain it to them. This is typically a good tip-off that you may be on the right track.
Making money selling options does not require a trader to pick the exact market direction. In many
Option sellers are not in it for the rush. They are usually serious investors seeking a steadier source of potential profits. Unfortunately, the only way most investors eventually find their way to option selling is by having failed at every other approach first.
Buying options offers the allure of a big payoff for a small investment. That is innate to human nature. There will always be buyers out there to purchase the options you wish to sell.
Be grateful for them.
Risk Reminder: Trading futures and options on futures involves substantial risk of loss and is not suitable for all investors. Certain option-writing strategies, particularly uncovered positions, may involve substantial or potentially unlimited losses. Adverse market movements may also result in increased margin requirements and the need to deposit additional funds. OptionSpreaders.com utilizes spread-based strategies intended to offset or limit certain risks, but spreads do not eliminate the possibility of substantial loss. Investors should carefully consider whether these strategies are appropriate in light of their financial condition, investment objectives and ability to bear risk. Past performance is not necessarily indicative of future results.
9
The option buyer has a good pitch on the surface. But if you scrape below the surface, the facts tend to speak for themselves. The concept of selling time premium has been used by professional and commercial traders for decades.
It has only recently caught the attention of individual investors.
Still, this does not mean option selling is easy, guaranteed, or without risk. Selling options requires capital, market selection, a risk plan, and the temperament to follow it. It is not suitable for every investor.
But for qualified investors who understand the risk, the objective is simple. Do not try to hit a home run. Seek to collect premium. Let time work in your favor. And know when to buy the option back and move on.
A disciplined approach is less about hitting home runs and more about consistently managing premium and risk.
How we select markets, structure credit spreads, and manage risk on the sell side of the trade.
