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When trading options, you can either be the buyer or seller of the option contract. You may be wondering, which is better? Buying or selling options? In this article, we are going to explain the three advantages of selling options. When you realize how the market favors option sellers you may think twice about being an option buyer.
But before we get started, you need to have some basic background:
Let’s get started on why selling options gives you higher probability of winning.
Options are a decaying asset. They decay with the passage of time; they expire. So even if other factors that affect an option’s price, such as the price of the underlying stock and its volatility remain the same, that option will be worthless at expiration. It will time-out.
The price of an option correlates with its time to expiration because of the greater probability of the option becoming in-the-money. The more time until expiration, the more chance the option can go in-the-money. Let’s compare option contracts with car insurance policies. How much is the car insurance for 1 year, $500? What about for 1 day, $10? Obviously, the more time to the pre-selected end of the policy the greater chance that an accident will occur, resulting in a higher the insurance premium to cover the increased chances of accidents, claims, and outlays.
This is the same with option prices. An option with more time (to expire) is more valuable. However, the option price becomes less valuable each day since the probability of getting in-the-money decreases daily – favoring the option seller.
The stock price can move in 3 directions: Up, down, or sideways. When you sell options, you can be profitable when the price moves in your desired direction, sideways, or even slightly in an undesirable direction.
Picking stock direction is a 50/50 bet. This is the main reason why we don’t look at indicators, use tools, set up support/resistance, or look at candlesticks when we trade in attempt to predict a direction.
Let’s take a look at selling a call option. When you sell one, you typically sell a contract with a strike price that is above the current stock price. For putting on this trade, you collect a premium as the option seller. In this case, the stock price can move in any or all directions, except go above the strike price (plus the premium collected) to be profitable at expiration. This means the stock can go down, it can remain unchanged, or it can even move up by a little in to win.
If you sold a $52 call option for underlying stock currently at $50 and took in $1.00 as option premium, the following could occur:
|Stock Price at expiration||
|Loss||The loss can be unlimited but there are ways to limit the loss|
Between $52-and $53
|Collect 100% of the premium|
|$52 and under||Collect portion of the premium||
Profit capped at the premium collected
As can be seen in the Table above, the option seller wins as long as the underlying price is below the strike price plus the premium collected. The option buyer can win only if the underlying price goes above the strike price, plus the premium paid.
The same is the case for put options. When you sell a put option, you sell it with a strike price below the current price and you will collect its premium as the option seller. The put buyer requires the stock price to drop below the strike price (plus the premium paid) to be profitable at expiration. But, put sellers only require that the stock price stay above the strike price to be profitable. Put sellers make money if the underlying stock goes up, remains unchanged, or even goes down a little.
Implied volatility is a complex subject which we will extensively blog about in the future, but in simple terms, implied volatility is a measures of the expensiveness of a given option.
Option buyers want to buy an option at a cheaper price and sell it at a higher price. This occurs when a call’s or put’s implied volatility is low, then subsequently increases. Conversely, option sellers want to sell when an option price is high and later buy it back when the price is cheaper. This occurs when implied volatility is high, then subsequently decreases.
We have found that high implied volatility has a tendency to decrease over time. This behavior is described as a reversion to the mean. The opposite action of low implied volatility increasing over time is harder to predict. We sell options that are expensive (high implied volatility) and buy them back when their implied volatility reverts back to norm, which it tends to do naturally over time. The main factor we consider is volatility when we trade. This simplifies our option-trading strategy when compared to typical traders.
When we are selling options, we are aligning all the factors of option pricing to our advantage: time, stock-price direction, and volatility. The typical trade we put on has a probability of profit upwards of 70%. We typically close the transaction way before the option’s expiration to give us the probability of success in the 90% range. The typical probability of “profit” for the average option buyer is only around 30% – hardly a success! The only way the typical option buyer can win is when the underlying stock price moves significantly in his or her direction. All other factors work against the average option buyer.
If you learned anything about the 3 advantages of selling options vs buying options, let us know in the comment section below!
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