Options are an increasingly popular financial product that gives traders numerous ways to manage risk while significantly leveraging capital. They are a powerful trading “tool” that can be bought, sold, and combined in a seemingly limitless number of ways to achieve a specific objective.
One of the bigger questions for new — and even experienced traders — is whether to be an options buyer or seller. Or both.
The price of an option is the sum of intrinsic and extrinsic (time) values. Intrinsic value is the mathematical difference between the option strike price and the price of the underlying. Extrinsic value is variably priced based on the expected volatility of the underlying and remaining time before the option expires.
Let’s go through some of the pros and cons of buying versus selling options.
Buying options seems like a simple enough strategy. The trader picks a bullish or bearish direction and goes long (buys) a put or a call corresponding to the stock’s anticipated directional move. Be sure not to confuse being long an option and being long underlying. For example, if a trader is long a put, due to inverse correlation that is akin to being short the underlying.
But being long an option is not as simple or easy as it appears. The first challenge with a long option is being right about the direction of the stock. The underlying has to move in the expected direction for the option to go up in value and possibly generate a profit.
The option buyer also has to be correct about the magnitude of the underlying move. If a trader buys an option and the amount of the move is not greater than what was spent for the time value, the option won’t be profitable. For example, if $2 is spent for options time value, but the stock only moves $1, it is quite possible to be right about direction but still not profitable.
The time value in options is a wasting asset as it will always approach $0 at expiration, so that works in favor of option sellers and against option buyers. Think of time value like an ice cube, melting away slowly at first and then more rapidly.
Since all options have a fixed time when they expire, duration is a significant consideration. A trader could be right about the direction and magnitude of the underlying move, but perhaps that doesn’t materialize sufficiently during the option’s lifetime. So enough time value has to be purchased for the move to happen. And more time value, of course, costs more money.
IMPLIED VOLATILITY (IV)
There’s also the effect of volatility. The time value portion of an option is priced according to the underlying’s anticipated (Implied) volatility. If an option is bought when volatility is low, and there is an increase in volatility, that makes the remaining time value portion of the option price more valuable. That can work in the option buyer’s favor. But there’s also the opposite situation; when an option is purchased when volatility is high, and there is a contraction in volatility.
It’s important to be able to gauge if option premium is underpriced, overpriced, or “average” priced. Technical tools to do that include charting implied volatility itself and some version of IV Rank where current IV is evaluated as a percentile of the range of IV over some time period, typically one year.
So the inherent disadvantages of a long option are the necessity to be correct about direction, magnitude, duration, and possibly implied volatility. These considerations can make the probability of profit with a long option relatively low, often far below 50%.
SO WHY BUY AN OPTION?
Simple – unlimited profit potential! Long options can generate outsized profits when the trader is right about direction, magnitude, and duration.
When does it make sense to use a long option?
- When a significant move in a stock is expected.
- When there’s a trend.
- When there’s a reversal in a range.
- When there’s a breakout (up or down).
Solid technical analysis and a keen sense of the specific market are key success factors.
For every buyer of an option, there is a seller (counterparty). Option sellers take on an obligation to either buy or sell and stock in return for collecting a premium.
There are a couple of disadvantages to selling options. The premium collected is the maximum profit possible. Selling an option also comes with a possibly substantial obligation to buy or provide stock. There are ways to reduce and manage that obligation risk, such as structuring trades as either vertical or calendar spreads, and these and others will be the subject of many future posts.
SO WHY SELL AN OPTION?
Probability of profit! Depending on how an option selling trade is structured, it’s possible to have a very high probability of success, sometimes 80% or more. It can be quite a bit easier to generate consistent, albeit smaller, profits with selling options.
So, in summary, buying options come with an inherently low probability of an unlimited profit. Selling options come with a relatively high probability of a modest profit.
WHAT DO I DO?
Both. But I tend to be an option seller much more often than an option buyer. That better suits my personal style in trying to generate consistent profits for income. Other traders and investors with different objectives may find a different approach works best for them.
Enjoy your day!
Founder & Chief Market Strategist