Opinions can be quite polarizing, particularly in the world of trading. When it comes to options, there are those who believe options should be traded and those who believe they should not. It’s just the way things are!
For the most part, option traders are convinced options provide the best opportunity to make a large profit quickly. And for the most part, those who do not trade options tend to think of options as too risky.
Interestingly enough, inside the world of stock option traders, there tends to be another polarization. Those who like to buy options and those who like to sell options.
Those who like to buy options typically do a very good job understanding the leverage and high ROI opportunities that options provide. But they tend to struggle with understanding why someone would take on the risk of selling options for what they consider a comparably low ROI.
In a similar way, those who favor option selling tend to appreciate the consistent, albeit lower, rate of return option selling brings. And they struggle to understand why option buyers would buy an investment that by its very nature is losing money as soon as the trade is initiated.
We spend a lot of time talking about options buying here at TSU so, in this post, I want to emphasize the benefits of selling options and maybe by the end some of your option buyers will reconsider whether or not options should be sold instead of bought.
Option sellers have a different philosophy about trading. They do not trade a play of pure speculation the way option buyers do. Option sellers are trading based on taking a strategic risk in exchange for a premium payout.
Think of State Farm or Allstate or any of the big insurance companies you are familiar to you. All of these companies do the exact thing.
An insurance company sells insurance policies and collects the premiums in exchange for taking on the risk.
Stock options are essentially the same thing. When you sell a stock option, you are taking on the risk of the trade, and in exchange for doing so, you get to collect the premium.
So to answer the question of “why?”…
The primary reason option sellers choose to sell is because they see it as a way to put the odds on their side.
Option sellers understand the nature stock options, and the nature of the marketplace:
An option seller wants to take these two components that make option predictability more difficult and put those factors in their favor.
The result is you become an option seller!
When you sell options, you are taking a short position. Just like shorting a stock, or futures, or forex, or anything else, you want the price of the instrument you have shorted to go down in value.
As a short trader, if you can put the odds on your side to see the price go down, you will consistently win. That’s what option sellers like about selling options.
When trading options, there are two ways the option price will go down in value:
There are a couple of other components that could impact option pricing, but these are the two primary components. A third, which is beyond the scope of this post, would be implied volatility (IV). Unless the market becomes extremely volatile, the IV will not impact your option a lot. However, if the market does become extremely volatile, IV is a third factor that could have a substantial impact on your pricing.
For the purposes of this post, let’s focus on the two primary impacts to option pricing.
Time decay impacts an option price by eroding the value of the option every day as it is getting closer to expiration. The principle is simple:
Time decay is a known factor of option pricing. We know it exists and we know we can’t avoid it.
As an option buyer, we are trying to choose trades that will outrun the time decay. But as an option seller, we want to work with the time decay to make a profit.
Think of it like ballroom dancing - you can fight your dance partner and the dance will become a disaster! OR, you could choose to work with your dance partner, and the dance will (hopefully) look like a well-coordinated work of art.
As option traders, we can choose to fight the time decay portion of an option, or, we can choose to work with the option taking it’s “weaknesses” and using them to our advantage. If we fight it, we could end up with a disaster. But if we work with the weaknesses of the option, we might just make our trading look like a work of art.
That’s what option sellers do.
As you can see, from the beginning, the option is losing money. But it really starts to lose money at the end of the life of the option! In fact, it loses money 4-6x faster during the last 2 weeks of its life than it does during the first 6 months!As option sellers, we seek to capitalize on that option price move. We sell the option and let the time value erode out of the option. Just like shorting a stock, we short at one price, and either cover at a lower price or in the case of the option - often times we just let it expire worthless.
When trading options, we have a 100% certainty that time decay will exist. However, we also must consider the fact that the stock price moves as well, and that will also impact the price of the option.
Calls go up when the stock goes up, and down when the stock goes down.
Puts go down when the stock goes up, and up when the stock goes down.
These probabilities are pretty easy to understand. Stocks can only move 3 directions:
As an option trader, we know when we buy a call option, there is a 33.3% chance of the option going up. And there is a 66.6% chance the option will stay the same price or go down.
Option sellers seek to capitalize on this probability. 66.6% of the time, the option will stay the same price or go down, and 100% of the time, time decay is at work.
With those odds set, the option seller has found the part of options trading that is more predictable:
All things considered, option selling is a much more predictable set of trades to place than options buying. If you are willing to take the risk of option selling, then the rewards can be very favorable because of the consistency with which you can create profits.
In a later post, I’ll talk more about the risks of option selling. In the meantime, here are the points I wanted to make: