Selling Options vs. Buying Options | The Complete Guide for Beginners
An option is a derivative of stock, ETFs, or future products. An options contract offers leverage similar to a futures contract, but contrary to them, the contract has multiple ways to trade. However, before jumping into the trade, we need to know basic concepts like theta, exercising, and leverage.
The main thing that we find common among traders and investors is that they struggle to understand when and why they should be buying vs selling options.
Therefore this article aims to enlighten you on the difference between both concepts and how to decide to best moments to buy or sell options.
The Differences Between Buying Options vs Selling Options
Let's begin by understanding the concept of buying vs selling options.
When you buy an option, the option buyer has the right to buy or sell the underlying security at the strike price.
Buying options are also associated or regarded as debit as you will pay the contract upfront.
In options selling, the option seller either has an obligation to buy or sell the underlying security at the strike price, which also depends on whether the option buyer decides to exercise the option.
When you are selling options, you receive money in the form of a premium for the contracts you have shorted. Receiving money just for placing an order can seem quite attractive to those in the stock market.
Not having any control over whether an option contract is exercised can be quite dangerous for option sellers. These sellers need to be aware of the risks before getting into positions. Losses created from using margin can put the trader into debt and ruin their financial future. Luckily, there are option approval levels and checks in place to help traders not take on more risks they are comfortable taking.
Buying options is quite a simple and easier concept for new traders to wrap their heads around. When buying a call option, they are giving from the upward movement in the underlying asset. While the opposite can be said about selling a call option. When selling, the trader looks for sideways or downward movement in the markets.
On the other hand, while buying the put options, the trader gets benefits from downward movement in the shares of the underlying asset. While the opposite can be said about selling a put option. When selling, the trader looks for sideways or upward movement in the markets.
To better understand these four opportunities we will dive into the advantages and disadvantages associated with buying vs selling.
Common Option Buying Strategies
Bullish Strategy – Buy a Call Option
A call option is generally considered neutral or strongly bullish views on the shares of the underlying stock.
As we can see from the call option greeks below if the stock moves $1 the option would increase by the amount delta which is $51. Theta is the amount the option loses value every single day which in this can is $19. If the stock were to fall $1, the option would lose -$51.
Bearish Strategy - Buy a Put Options
Opposite to buying a call option, buying put options offers the owner the right to sell the underlying asset at the option's fixed price.
As we can see from the put option greeks below if the stock decreases by $1 the option would increase by the amount delta which is $48. Theta is the amount the option loses value every single day which in this can is $18. If the stock were to rise $1, the option would lose -$48.
Advantage: Larger Possible Returns
In buying the options, the option buyer has the potential for unlimited profits. As seen in the risk-to-reward chart below.
The factors that affect a long options profit are the price of the option and the amount of delta. The cheaper the option costs and the higher the delta reading the faster the option will increase in value as the underlying stock moves.
The key to these large returns is to time the move in the underlying stock correctly. When done perfectly that is where the trader can see the fruits of the labor.
Disadvantage: Constantly Decaying
Long options start to lose value instantly. Depending on the expiration date of the option the loss of value can be slow or extremely fast. This is called time decay. An option buyer who tries to keep the option for a long with the hope of maximum money profit is fighting an uphill battle of time decay.
Making a profit is contingent on the stock moving fast enough to beat the time decay of the option. At the time of expiration, if the option is out of money, it expires worthless. Having option premium completely lose value by expiration is the one caveat of buying options.
In the table below we can see that if a stock fails to move the option will lose money every single day. The white line indicates the amount the stock needs to move just to break even. Depending on how far out of the money the option is will decide how fast the stock needs to move.
In the example below we can see that the stock needs to move about $5 per month just to pay for the decay. If the options trader was wrong about the direction the option can lose value even quicker if we add in the amount of time decay.
Disadvantage: Correctly Timing the Market
Buying options is the game of the stock market and perfect timing. Timing the market is the method of predicting a directional move and being right in the specified amount of time.
With options predicting the move within a time frame is absolutely crucial in order to beat the time decay.
It is a challenge for the option buyer to earn big by correctly timing buy the option just before the prices fluctuate.
The amount of traders that are able to beat the market every single year is extremely low that is why buying options can be a zero-sum game.
Disadvantage: Lower Potential Chance of Profit
Options statistically have a chance of profit that is calculated from most brokers like Robinhood. This number allows traders to gauge the possibility of success even before entering a trade. Typically buying options inherently have a 40-50% chance of profit depending on the expiration date, volatility, and theta.
Common Option Selling Strategies
Bearish Strategy – Sell Call Options
The selling calls option is considered the bearish or neutral strategy.
For example, AAPL is currently trading at $146.80. If a trader was to sell a call option out of the money the stock would need to stay under $149.76 to receive the full option premium.
This is considered a bearish strategy but the option can still make money if the stock were to move slightly higher or trade sideways.
Bullish Strategy – Sell a put option
Selling a put option is a bullish or neutral strategy.
For example, AAPL is currently trading at $146.80. If a trader was to sell a call option out of the money the stock would need to stay above $143.00 to receive the full option premium.
This is considered a bullish strategy but the option can still make money if the stock were to move slightly lower or trade sideways.
Option Selling Advantages and Disadvantages
Advantage: Create Income with Decay
Option sellers receive the profit from decay. The value of purchased options decays with time. As the expiration time approaches, the possibility of an option moving in the money also minimizes, which ultimately results in a worthless option.
It is a different but beneficial aspect of selling options. The stocks generally move down as the expiration date approaches. In this case, losing value proves beneficial for the investor. It is a safer strategy that profits typically the investor.
The exact same option we bought in the table earlier if we sell the option the table flips. As you can see in the table below, the option will make the seller money every single day if the underlying asset stays the same price. Even if the underlying asset increases in price the option still has the ability to expire worthless.
Advantage: Higher Potential Chance of Profit
Some platforms like Robinhood show the statisictics on selling options. These numbers can be seen in the chance of profit section that helps option sellers understand the chance of the option expiring worthless.
Option selling strategies inherently have a very high chance of success because of how many option decay worthless every single week. When time decay is working in the sellers favor option selling can be quite attractive for all investors.
Advantage: No Need to Time the Market
As shown in the table above, when the stock trades sideways, drops, or even pops the option has the ability to expire worthless. When the option seller has the chance to make money in every single scenario the seller doesn't need to enter into the position at the perfect time.
Disadvantage: Smaller Possible Returns
While selling a call option, the buyer pays you a premium option. The premium payment you receive is the maximum profit you can earn from the transaction. The option buyer has the ability for infinity returns with a capped loss which is flipped for the option seller. The seller has the ability for infinite losses and capped gains.
Lower the potential profit can be a huge turn-off for traders who are too impatient in the stock market. The amount of profit and the time to make that amount is the reason many stick to option buying.
While theoretically, the seller has infinite possible losses, they have the ability to cap the losses by owning the underlying stock, having the cash to buy the stock, or owning a long option as protection. Most trading brokerages will not allow the traders to sell uncovered options unless the traders have level 4 approval which is extremely risky.
When Should One Buy or sell Options?
Experienced option sellers know the right time to buy vs sell options.
Buying options is favorable in low implied volatility environments and when you expect significant fluctuation from the underlying stock.
On the other hand, selling options is appreciated in a high implied volatility environment. If a stock has recently made a big move and is no longer in trend, this will be a great time to sell options.
Keep in mind that while selling the underlying option, you can also generate profit from directional and sideways premium movement.
It is wrong to say that there is any thumb rule or right to buy or sell option. There are many ways to generate money in buying vs selling options while following different strategies. The deeper you dive into options trading, you will find a myriad of strategies and their multi-directional working for both buying and selling options.
By comprehending some common strategies, you can understand their way of working with underlying stocks and the probability of profit and loss.
To further understand the differences between buying and selling options, get ready to start the dive because practical teaches you what you cannot learn from theory.