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You may be under the impression that buying an option is the best strategy because you have defined risk and can quickly make a lot of money, or you may have heard that selling an option is best because you have the odds on your side. So which is the right answer or the right thing to do?
The answer is that sometimes buying an option is best and, at other times, selling is best, depending on what you are trying to accomplish and your views of the underlying stock or the overall market.
So, let's start with some basic explanations and discuss the facts about options buying and options selling.
When you buy an option there is someone selling it to you and vice-versa. Now suppose you are a seller of an option, you collect the option premium (at the time of executing the trade) from the option buyer.
Your goal is to buy it back at a lower price, or the contract lapse so that the premium becomes 0. The buyer’s goal is to sell it at a higher premium than what was paid to enter the transaction.
There are several factors that affect the price of an option, but the primary threefactors are time to expiration, price movement that is the direction of the underlying stock relative to the strike price, and volatility.
Now it has been seen that a seller of an option has 2/3rd chance of making profit whereas a buyer of an option has only 1/3rd chance of making profit.
Let me throw some more light on this as to why selling options gives you a higher probability of winning.
Time Decay is always in the favour of the Option Seller
Options are a decaying asset. The premiums decay with the passage of time and they expire. So even if all the other factors that affect an option’s premium price, such as the price of the underlying stock, its volatility remain the same, that option will be worthless at expiration.
Time decay always works in favour of the option seller and against the option buyer.
Second thing to note is that at any point of time the stock price can move in threedirections: Up, down, or sideways. When you sell options, you can be in a profitable position when the price moves in the direction which youwant it to move, or if it moves sideways, and evenslightly in an undesirable direction.
Let’s take a look at an example by selling acall option. When you sell a call option, you normally sell a contract with a strike price that ishigher than the current stock price. By entering in this trade, you collect the premium as being the option seller. Now once you have entered into this trade, the stock price can move in any direction, meaningthe stock can either go down, it can remain unchanged, or it can go up by a little to be in a winning situation.
If you sold a ₹520 call option for underlying stock currently at ₹500 and took in ₹10 as option premium, the following could occur:
As it can be seen in the table above, the option seller earns as long as the underlying price is below the strike price plus the premium received by him.
The option buyer earns or is in profits only if the underlying price goes above the strike price, plus the premium paid.
When you are buying an option, there are two things which needs to work in your favour.
The first is the stock direction, and the second is volatility. If the volatility of the underlying doesn't increase, the premium value decreases, and options buyers face losses.
Hence the trader has to keep the above factors in mind before deciding whether they should be buying or selling options.
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