Options give traders powerful tools to seek out trading opportunities in any market condition. You should know: trading options comes with risk. It’s true that option buyers can come across big opportunities, but the option pricing formulas actually favor option sellers.
Buyers have two challenges. All options come with a built-in expiration date and a daily loss of time value. Let’s take a closer look at the pros and cons of overcoming these challenges.
It is true these two challenges can be overcome if a buyer happens to get lucky enough to make a trade at just the right time.
This kind of timing is not easy to predict. That’s why it’s important for traders to weigh the advantages and disadvantages of trying to time trades. The alternative to being a buyer and seeking opportunities for well-timed trades, is to become an option seller. Some traders prefer to take that approach because it allows them to focus on risk management, rather than timing.
So let’s compare the difference between being an option buyer as opposed to the advantages of being an option seller.
#1. Opportunity to experience windfall profits
You may not always be right about an option trade, but if you are, the opportunity for unusual returns does exist.
#2. You can clearly define how much you will risk
You may not always have a winning trade as an option buyer, but when you have a losing trade, you have a clear understanding of how much money you put at risk when you made the trade. That’s because option buyers pay a premium, and their risk is largely limited to that premium.
#1 You get to collect time value instead of paying it
Options are priced to favor the sellers. That’s because sellers set the price. They do this in a way that covers most of their risk. The price of an option reflects what the seller expects to see happen with the stock. If they expect the stock price to move strongly against them, they set the price of the option higher. As a result sellers are more likely to be successful every day the stock closes without big moves.
#2 You don’t need to have excellent timing
Since option sellers benefit from time decay, and since time decay happens every day, an option seller doesn’t have to worry as much about initiating the trade on an exact day. As long as the stock doesn’t move against them rapidly, sellers have a higher frequency of opportunities for good trade setups.
It’s also true that each decision comes with tradeoffs. For example, those who buy options have the potential for a big profit, while those who sell options give up that potential in exchange for smaller, more frequent opportunities.
Another tradeoff has to do with how much an option trader must risk. The premium a buyer pays represents their entire risk of the trade. However, sellers take on much more risk in exchange for the premium they collect. That’s because when a trade goes against a seller, the losses aren’t limited to the cost of the option premium, but the potential profits are.
A good rule of thumb is that option buyers will experience less frequent gains but have correspondingly larger trade profit potential compared to the risks they take. By comparison, option sellers will experience more frequent opportunities but take correspondingly larger risks compared to the premium they make on the trade.
These pros and cons tend to balance out in such a way that neither side has much mathematical advantage over the other. However once a trader has picked a side, they also have to select option strategies that work best for that kind of trading.
Buying call options
Profiting from a speculation that a stock price will rise, starts with a “Buy to Open” order for a call option contract.
This is a directional strategy that is best implemented in a strongly bullish market.
To acquire the rights of the selected call option contract, the option’s premium is debited from the investor’s account. For most options, the benefit associated with this contract is the right to buy the stock at the strike price any time on or before the expiration date of the contract.
Buying call options is a leveraged strategy, but not a strategy that requires the use of margin. Therefore, the net debit required to purchase the contract represents the risk of the trade–or in other words the maximum amount of loss the trader could experience if the stock does not make a favorable move quickly enough. On the other hand, if the stock price moves up unusually strong in a short time frame, the amount of profit a call option buyer can make could be much larger than the amount they had at risk. That’s the big appeal of buying call options.
Those who buy a call option pay for the time available in the contract, but remember, time value always decays. Since time decay works against them, call option buyers should carefully execute trades only when they anticipate an unusually strong rise in price. This big move is what they need to be able to overcome the loss in the premium related to time decay.
Now there are often a large variety of strikes and expiration dates to choose from. It can get confusing. The best strike price and expiration date to choose will depend on how long a trader thinks it will take for a big move to materialize. This is a big challenge.
But that is where trade alerts can help for those who have purchased our alert service, We take great care to match the correct option strike with the anticipated move. When you receive an alert email informing you of the opportunity, we have already taken into account the pricing of the option, the anticipation of the move and the length of time it will take to play out.
That’s why each trade alert specifies a limit price you can use, and the optimal expiration date for buying enough time to see an unusual move materialize.
So those are the key details of option buying. In the next segment we will look at the other side of the coin: selling call options.
Selling Call Options
Some traders, especially professional market makers, like the idea of collecting that time decay, rather than paying for it. They do this by offering options for sale. Because the most commonly purchased option is a call option, they spend most of their time selling call options.
They try to sell option contracts at a price that represents a larger move than the stock is likely to make. If the seller guesses correctly that the stock won’t make an unusual move, they get to keep the money they collect from the option buyer. Sounds fantastic, right?
Some people like to think that selling options can allow you to sort of collect a paycheck from the market. They say it that way because they imagine collecting time decay regularly–every time an option expiration date rolls around. But hang on a bit and you’ll see that this isn’t exactly easy money.
Now it is true that you don’t have to be a market maker to sell options. Anyone can do it. This strategy is initiated with a “Sell to Open” order.
Most traders imagine that selling call options is a non-directional strategy, That’s because the stock can either go down, sideways or even up a little bit, and the option sell can still make money. But the truth is that those who sell call options really would rather see the price of the stock go down. That makes the call option lose its value the fastest, and gives the option seller the best chance to capture a profit quickly.
That’s important to option sellers. Because option sellers take a big risk! Let me explain why.
Recall how call option buying works. Remember that when you pay for an option, the total cost of the trade is the maximum risk, right? We’ll answer this question in your mind: what is your maximum risk when you sell an option?
The answer is that the risk for the seller is not the same amount as the option buyer. It is much bigger, in fact.
That’s because the gains a call option buyer can make, at least in theory, are much larger than the amount of money they had to risk. Who pays out that money? The unlucky option seller.
The seller of the option contract has to fulfill the terms of that contract.
That means the seller has the obligation to provide the shares of the stock if the option buyer wants to exercise their right to do so. So if Trader #1 decided to sell a call option to Trader #2, and the stock price moves up dramatically right after that, then Trader #1 can exercise their right to buy the shares, and Trader #2 is obligated to go purchase shares at the going rate and sell them to Trader #1 at whatever strike price the call option is based on. This can make for big losses.
The good news for sellers is that they usually win most of their trades. The bad news is that when they lose trades, those losses can be much bigger than their typical gains.
One of the ways selling call options can be made more profitable is to only sell call options connected with stock shares you own. That is what as known as selling a covered call. Traders use the term covered because the seller has enough shares to cover their obligation.
Some traders sell call options, even though they don’t currently have shares enough to cover their obligation to provide shares. This is known as selling naked call options, because they leave the trader exposed to large losses.
You can imagine that brokers are careful about whether they allow traders to sell call options naked or covered.
A covered call position is considered by many brokers to be safer. That’s because having the stock shares available keeps the option seller from having an unlimited amount of risk. So it is not surprising that many brokers allow traders to sell covered call options in their IRAs. The obligation to sell the stock at the strike price is “covered” by the stock itself.
A naked position, not owning shares when you sell a call option, can make large losses if the stock jumps higher in price rapidly. That’s why brokers usually require special permission to be able to sell a call option without owning any shares of the underlying stock.
By now you can appreciate the difference between buying and selling call options. Selling call options tends to make money more frequently, but the potential for large losses is always there. That risk potential is what the option market makers constantly face when they sell option contracts. This risk makes them prefer to see stock prices go down, rather than up.
But selling call options is not the only way to profit when stocks go down. In the next segment we’ll look closer at the most obvious strategy for profiting from downward moves in stock prices: buying put options.
Buying Put Options
Put option contracts allow a trader to profit from downward moves on stocks. This kind of contract can help an investor protect the value of the stocks they have in their portfolio, or to leverage a speculation that prices will fall.
Initiating this trade requires a “Buy to Open” order to acquire the put option contract. A put option contract allows the holder to exercise the right to establish a short-selling position on the underlying stock, though they are not obligated to do this if the position is worthless. The right associated with this contract is the right to sell the stock at the strike price anytime, on or before the expiration date of the contract.
Buying put options is a leveraged strategy but not a strategy that requires the use of margin. Therefore the cost of the trade represents the entire risk of the trade. If you buy a put option for the price of three dollars per share, and the price of the stock goes the wrong way, the most you could lose by doing so is three hundred dollars.
Option buyers pay more for options that have longer expiration dates. So those who buy a put option also pay for the time available in the contract. A put option with a strike price of $100 and that expires in two weeks will cost less money, than a $100 put option that expires in two months.
But no matter how much time is left before expiration, the price of options will deteriorate with the passage of time. That’s why this strategy is best executed when a trader anticipates a significant drop in prices.
Now buyers of put options have something in common with buyers of call options. Both groups of traders find that they have the challenge of overcoming the effects of decaying time value. As a result, they may expect to lose money more often than not. By contrast, when the trade does go well, it can create larger profits than the initial risk of the trade.
It is useful to point out that this kind of trading is similar to the hunter approach mentioned in the Foundations course, and it might be worth revisiting that idea now that you understand options better.
In the next segment we’ll look at the other side of the put option trade and explore what happens when a trader sells put options.
Selling Put Options
Traders who sell put options, whether market makers or individual traders alike, are taking the opposite position of the put option buyer. What that means is that they will benefit from selling put option contracts if the price of the stock goes up, or even simply holds a steady value. So even though these traders are working with put options, by being a seller of these options they are executing a bullish strategy.
There are two general goals that a put option seller might have for selling these contracts. The first goal is to capture decaying time value, but the second goal could be an attempt to purchase the stock at a discount. Let’s look at both of these goals separately.
The goal of capturing time value is the main focus of professional option sellers who make a market for option buyers. They hope to charge just enough for the option that the value of that option will decay away before expiration. Of course they recognize they are taking the risk that the stock may move in favor of the option buyer.
Now that you understand the four types of options trades, the next step is to begin practicing them.
Professional airline pilots use flight simulators. Professional athletes spend countless hours practicing drills and memorizing moves. Professional musicians practice until everyone around them gets sick of hearing them play. And yet somehow, most beginning traders think it is a good idea to simply take an option trade without an instant spent practicing.
Thankfully, you can practice your option trades and strategies using the TradeTool included in your subscription. There are certain steps you’ll want to take as you practice option trading. These are steps anyone should take when making actual trades in a live market, so it makes sense to begin by practicing properly.
Step 1: Plan where you are going to get out of your trading position, even before you enter the trade.
This is a big mistake most uninformed traders make. The idea that you should simply jump in and initiate an option trade without any concern for how you plan to close the trade can lead to unpleasant endings. It’s not that hard to simply say to yourself or write down your plan for what price you’ll exit the trade in both a best-case and worst-case scenario.
Step 2: Identify whether you will get into the trade using a limit order or a market order.
Most of the time a professional trader will use a limit order to enter a trade, but many of them do recognize that there are exceptions to this rule. If you don’t know a good reason for having such an exception, then it is unlikely that you need to practice with one.
Step 3: Identify the number of option contracts you will apply to the trade.
A good rule of thumb is that you shouldn’t risk more than two percent of your capital in any one option trade–especially if you are buying out-of-the-money options as your strategy.
Step 4: Identify a real-time quote and watch to see that your trade would have been entered at the price you specified.
Step 5: Monitor the trade until it hits either of the conditions you specified in Step 1. Record the results and make notes of anything you learned. Keep a running tally of any hypothetical gains or losses that might have occurred in the simulation.
Step 6: Repeat steps 1 through 5 up to 30 times and check your results. If your simulated trading results do not sum up to a positive gain, then you probably need to keep learning and refine your technique.
Practicing option trading in just this way can go a long way to avoiding unforced errors. Those are the kinds of mistakes that would cost a trader money in real trading but could have been easily avoided with some practice.