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So, which is better? Should you be a buyer or a seller of options?
In a previous video and article called “What are options” we touched on the basics of options and I would suggest that before reading this article that you have a look at either of them before continuing.
When trading options we can open different positions depending on the what we think an underlying will do. Let’s, look at the option compass below to help explain the different option positions.
- If you are bullish and you think the price of a stock will go up, then you can buy a Call or sell a Put.
- If you are bearish and you think the price of a stock will go down, then you can buy a Put or sell a Call.
Buying an option involves paying a premium up front for the right to purchase the underlying asset at a specified price on or before a specified date. The premium is made up of its intrinsic value, which is based on the price of the stock and its extrinsic value, which is based on the time value and volatility.
Options Buying
Let’s look at the payoff diagrams (below) for buying a Call and a Put. From these diagrams you will see that buying a Call option is worth more if the price of the stock goes up. You have unlimited upside profit and a limited downside loss which is equal to the premium paid for the contact. Buying a Put option is worth more if the price of the stock goes down. You have unlimited downside profit and a limited upside loss.
Option buyers need the price of the stock to move in their desired direction, and the movement needs to quick. In other words, they need the contract to quickly increase in intrinsic value. The big problem for an option buyer is that contracts are wasting assets and they lose extrinsic value from time decay.
Option Selling
Selling an option involves collecting the premium up front from the option buyer and sellers are obligated to take shares if assigned.
Let’s look at the payoff diagrams for selling a Put and a Call (below) . From these diagrams you will immediately see that this is the inverse of the buying payoff diagrams. If you sell a Put and the price goes up then you have limited profit and an unlimited downside loss.
Selling a Call option is worth more if the price of the stock goes down. You have limited downside profit and an unlimited upside loss.
Option sellers are more interested about where the price will not go. If it moves in their desired direction or does not move at all, they will still make money as the option premium losses extrinsic value from time decay.
Looking at all the payoff diagrams together, you can see that option trading is a zero-sum game and the buying payoff diagrams are the inverse of the selling payoff diagrams. To trade options successfully you need to understand the differences between the two and use this to your advantage.
So, the question, is it better to be an option buyer or an option seller?
If you are an options buyer then you should use this if you are fairly sure the stock price will have a big move in your desired direction. It is best used if volatility is low the contract needs to be far enough out in time so you don’t lose money from time decay. Ensure that you have a stop loss in place if a trade goes against you and take profits.
Generally, the buyers have a lower win rate or probability of profit but have a higher rate of return.
If you are an option seller then this should be done when you think the stock will move in your desired direction but there is some leeway if you are wrong. The seller will still make money even if stock moves slightly in the wrong direction. It is best used if volatility is high and the contract will make money from time decay. Remember again to have a stop loss and to take profits.
Statistically sellers outperform buyers by a ratio of 60/40 and the main reason for this is because of options lose extrinsic value from time decay. The problem for option sellers is that they may have a higher probability of profit but they have a lower rate of return.
SUMMARY
Both buyers and sellers of options can make money but the key to trading options successfully is to understand the slight differences between the two, use them correctly to your advantage, have good money management, control risk and take profits.
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