Selling options
Selling options
The opportunity
Market prices move in random ways which are both uncontrollable and unpredictable. Option buyers try to predict and profit from this movement. Option sellers try to profit from the passage of time without a large move.
Options give traders powerful tools to seek out trading opportunities in any market condition. Traders can use calls and puts to speculate from either rising or falling stock prices. But there is an alternative to buying options and speculating on price. Option traders can choose to option positions as a seller, rather than a buyer.
Option buyers purchase a chance to either buy a stock or sell it short, but option sellers look for a chance to capture the price of the option itself. This approach is quite different from speculation of price movement and represents its own set of challenges and opportunities. Option traders should learn how both option buying and selling approaches work.
The difference between the two approaches is a difference in probability. It’s true that option buyers can come across big opportunities, but the probabilities built into option pricing formulas actually favor option sellers.
That’s because buyers always face the same two challenges on every trade: a built-in expiration date and time decay. Sellers face a different challenge: the risk that the stock may move strongly in favor of the buyer.
The pros and cons of buying options
First consider the benefits of being an option buyer: big opportunity and limited risk.
Option buyers have the opportunity of enjoying big profits. They may not always get the timing right on an option trade, but if they do, the opportunity for unusually large returns does exist. The challenge of being a buyer is that option prices are usually set in such a way that buyers have a lower probability of winning their trades than losing them.
Option buyers speculate on the direction and magnitude of a future move. Speculating on price action is like going into a casino with a wad of cash in your pocket hoping to hit the jackpot.
The second benefit for option buyers is clearly defined risk. Their risk of loss is limited to the premium they paid to get into that option.
The pros and cons of selling options
The benefits of being an option seller are different. Sellers get favorable pricing and probability in comparison to option buyers. But it comes at a cost.
The first benefit option sellers have is they get to collect the option’s premium instead of paying for it. A large part of this premium is comprised of time value which shrinks as time passes.
Since time decay happens every day, option sellers benefit from this daily dynamic. If the stock price does not move strongly in the option buyer’s favor, then time decay ensures that the seller will be more likely to see their position benefit.
The second benefit is that option sellers don’t need to have excellent timing. Options are priced to favor the sellers, because sellers set the price in a way that covers most of their risk. The price of an option reflects what sellers expect 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. This market action means sellers are more likely to be successful every day the stock closes without big moves in the buyer’s favor. That is why 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 opportunity, 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 will 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 collected, but the potential profits are.
A good rule of thumb is that option buyers will experience less frequent opportunities but have correspondingly larger trade setups compared to the risks. By comparison, option sellers will experience more frequent opportunities but take correspondingly larger risks compared to the cost of the trade.
These pros and cons tend to balance out in such a way that neither side has much mathematical advantage over the other.
The market maker role
Trading in every market is facilitated by market makers. Market makers sell to buyers whenever the buyer wants to purchase. Market makers also buy from impatient sellers who don’t want to wait around.
Market makers work to match buyers to sellers (and vice versa) but part of their role is to step in and take the opposite side of the trade no matter what. This is especially true for those who make a market in options.
Market makers most often act as sellers because most of their clients want to buy. Option market makers create as many option contracts as necessary to satisfy buyer demand.
Selling options incurs and undefined risk that could be quite large if the underlying began aggressively moving in the wrong direction. To reduce their exposure, option market makers have developed a number of strategies for selling options known as spreads that can be adopted by any trader.
These various option selling strategies require a fair amount of judgement and skill to use effectively. However, anyone who choose to employ option selling strategies can act like the market maker and set the strike price and expiration date of the contracts they want to sell.
Act like a casino
Casinos make money despite paying out huge jackpots and numerous smaller claims. This is because they set themselves up to win and the only way they lose is when people stop playing their games.
In the gaming world, the casino has a predefined advantage. They can set the rules of their offered games carefully. These rules are designed to take in more than they payout over many trades. In this way those who sell options are similar to casinos. However, selling options differs from being a casino in some key ways.
First, unlike casinos, option market makers must compete with other market makers to attract business. Generally there are at least two and sometimes many more market makers making a market and offering their wares for sale. The bid and ask prices of all these market makers are listed and individual traders may then choose the one they want to do business with.
This competition for business keeps prices fair and results in a more liquid market.
Second, unlike the odds calculated by casinos, the fluid nature of the markets means the payouts and odds for each option contract are always theoretical and never precisely exact. This is a risk taken by market makers (and option sellers) and it’s where opportunity can be found.
Traders who adopt option selling strategies start with the pricing set by professional market markets. This is a good thing because even inexperienced traders get to benefit from the efforts, expertise, and research of more experienced trading professionals. This is one of the reasons why selling options can be so attractive.
A high probability of winning
Option selling strategies can be used win a variety of ways but the most popular strategies all will win more frequently than they lose. The probability of a winning trade is inversely proportional to its potential profit.
As described in this lesson, Win Frequent and Win Frequent Extreme traders willingly sacrifice the potential opportunity but low frequency of windfall profits for a higher frequency of smaller sized gains. Traders who sell options must be sure that the balance of small wins overcomes the occasional large loss.
The risks associated with selling options can be reduced when combining the sale of an option with the purchase of another option in strategies known as spreads. Combining two or more option contracts together creates a spread trade.
Spread trades that put money into an account are known as credit spreads and these are option selling strategies with clearly defined opportunity and undefined risk. A future lesson will go into more detail with the various spread strategies and how option sellers may reduce their risk in various ways.
The challenge associated with selling options
One of the most persistent challenges all traders face is the natural human bias for positive reinforcement. This is especially true for those who choose to sell options as this is a strategy with high positive feedback.
The challenge for many part time traders is that they have a negative inner dialogue about their trading…even with profitable trades! This negative dialogue is usually triggered by three situations:
- A trade that loses immediately
- A profitable trade that turns into a loss
- Capturing profits too soon and missing out on a big run
All traders regardless of strategy must content with this realities.
The two main risks faced by option sellers are:
- The underlying may experience a dramatic rise in price
- The underlying may experience a dramatic drop in price
Missing out on a dramatic rise in price may tempt the trader to either adjust the strike price to capture more of the potential appreciation, or delay selling the option in hopes of getting a more favorable price based on a move. Both decisions reduce the focus on cash flow generation and change the strategy of selling options into one of speculation.
If the underlying were to experience a dramatic price move in the wrong direction, the seller will experience a loss potential equal to the profits earned by selling many options. This may tempt the seller to stop selling options or to find ways to hedge their risks…both of which reduce focus on cash flow and reduce the premiums that could otherwise have been earned.
Option sellers get paid higher premiums on more volatile stocks. But more volatility also creates more risk. Volatility is the very element which creates the opportunity for selling options but it’s also the one that might make it hard for traders to take advantage of it.
Option sellers get paid a premium when they enter in to their contractual obligation. This obligation caps the upside that could be experienced by those who pay the premium and choose to speculate.
This obligation creates two risks. First, the option seller will miss out on the potential of windfall profits if the underlying makes a strong move in the right direction.
Second, the option sellers carry a large risk of loss if the underlying makes a strong move in the wrong direction.
These two risks may make it hard for trader to continue this strategy.
Entering an order
There are a number of predefined option strategies that can be employed to profit from market moves. In general, these strategies can be categorized as either speculative or cash-flow generating.
Those who speculate on market moves simply initiate a “buy to open” order with their broker using either a call or put, depending on the expected direction. Because options are leveraged trading instruments and cost a fraction of the stock itself, any move in the stock creates a much higher percentage gain in the option.
The cash flow generating option strategies are initiated with a “sell to open” order.
Those who sell option contracts believe the stock won’t move as far or as fast as the contract buyer thinks. In exchange for obligating themselves to the terms of the option they sold, they get to keep the premium paid by the buyer of that option. In the next section, we’ll look at option strategies from both the point of view of buying and selling option contracts.
Trading Options
Option market makers list their available options and brokers collect this data to present the option chains you see when you want to place an order.
If you’ve seen this kind of data table before, you know that option chains are sorted by option type, expiration date, and strike price. Each of the options in these tables has a bid price and an ask price.
The ask price is what buyers pay in premium to acquire the option and the bid price is the premium that is paid to the seller for entering into the obligation. While the market is open and stock prices fluctuate, these prices constantly change.
The difference between the bid and ask price is called, the bid-ask spread.
All option contracts are offered by market makers. Market makers will usually create as many new contracts as necessary to satisfy demand, so long as they can absorb the risk that comes with doing so. The easiest mechanism they have for controlling risk is the size of the bid-ask spread.
The daily count of contracts traded is what constitutes trading volume for the option, and the number of contracts which haven’t been exercised or closed is known as open interest. If trading volume and open interest are low, the professional option sellers (the market makers) will widen the distance between the best bid and ask prices they offer. That allows them to make just a bit more money on each trade, to help them absorb the risk of loss.
If the bid-ask spread is wider than normal the options are not highly liquid. Illiquid options present a risk to option traders.
One thing to note is that whenever an option position is entered, it will show an immediate loss because of the price difference between the bid and the ask.
One technique options traders commonly use to reduce the cost of the spread is to use limit orders. They will try to work with their orders to place them inside the spread. This can potentially get them a trade execution with more favorable prices than the currently published Bid or Ask prices listed in the options chain.
Example of selling a cash covered put
Consider a put option contract with a strike price of $95, on an underlying stock with a price trading at 100. Now put options run in an opposite direction from call options, so strike prices below the currently trading stock price have no intrinsic value and are considered out of the money.
A put option seller who offers the $95-dollar strike contract for $2 per share, will hope that stock price remains above $95 all the way until expiration. If their trade goes well, this action will allow them to collect $200 for each contract they sell.
However, imagine that the trade doesn’t go so well for the seller. If the stock price falls to $85 at expiration, then the put option contract has an intrinsic value of $10 per share. That’s because the put option buyer can exercise their right to sell their shares at $95 dollars per share and then make their profits by closing the trade by buying the stock back on the open market at its current, lower price of $85. This scenario would mean that the put option seller would have a loss of $1,000 per contract they sold.
It is worth noting here that option sellers win this trade more often than they lose, so even if they make occasional large losses, it is quite possible for them to execute this strategy profitably over many trades. You might remember that this kind of approach to trading is referred to as Win Frequent or Win Frequent Extreme on other areas of the curriculum.
Now the second goal for selling put options could actually be to acquire the stock at a discount. Assume a trader really wants to own a stock. They could choose to go out into the open market and pay the current full price.
However, they could also choose to sell puts as a way to get paid while waiting to buy the shares. It’s possible the trader may be able to sell puts many times before acquiring the shares at the contractual price they agreed to. If the trader has enough cash in their account to acquire the shares and also wants to own those shares, this can be a nice strategy to reduce the cost basis before ever getting into the position.
Executing this strategy in this way is also known as selling cash-covered puts. The name refers to the fact that the trader has enough money to cover the cost of the stock purchase.
By contrast, if the trader sells the put option but doesn’t have enough money in their account to cover the cost of the stock, then they are selling what is called a naked put option. It’s called that because the trade is uncovered. This is a much more risking way of selling puts.
Assignment Risk
Option buyers pay a premium for the right to buy shares at the strike price anytime during the life of the contract. Most option buyers don’t exercise this right, preferring to sell back their option contract as a less expensive and easier way to capture profits.
Option assignment is the term used to describe buyers exercising their contractual rights and sellers being forced to fulfill their contractual obligations.
There are three levels of Option Assignment Risk:
- Extremely low: Out of the money option prior to expiration.
- Low: In the money option prior to expiration.
- Guaranteed: In the money option upon expiration.
There are two specific instances when option buyers may choose to exercise their rights prior to expiration which are then assigned using a lottery system: If selected, the option seller must sell them their shares.
The first is during times of high volatility, when brokers may artificially limit the number of shares available for purchase. In this instance, an option buyer may choose to buy an option and then immediately exercise it to get the shares.
The second is on stocks with limited option open interest. If open interest is less than 100 and an option buyer decides to exercise their right to buy shares, the option seller is likely to have their stock called away early.
Remember, option sellers receive a premium for obligating themselves to sell their shares at the strike price of the contract. The only way an option seller can remove this obligation is to buy the contract back, which can be done anytime until expiration.
Option buyers and sellers neither know, nor care, who is on the other side of their trade. In fact, an option buyer may buy an option from someone and sell it back to someone else.
It’s up to the market maker to match buyers and sellers for each stock option, at each strike price, and at each expiration. If they can’t find someone else, they become the other side of the trade.
Because the risk of early assignment is so uncommon, many option sellers don’t fully realize that it is continuous. In other words, it’s possible that a buyer of an option may choose to exercise their option before expiration, and if chosen, the option seller would then be obligated to sell their shares at the strike price they agreed to.
Why a buyer may want to exercise their option prior to expiration has to do with the way options are priced. Our next lesson will discuss how options prices change.