The world of options trading may be gaining popularity worldwide, but some areas still need clarification. Like – what’s the difference between buying vs selling options? Which strategy is better and in what situations?
We’re going to break down these basic concepts as well as share some key strategies behind them.
Differences Between Buying and Selling Options – The Basics
Just like with stocks, when it comes to options you have the choice of whether to sell or buy them.
When you buy an options contract, you are effectively making an upfront payment for the contract. The price you pay for securing the options contract is known as a premium. Generally, the further away you are from the contract’s expiration date, the higher the premium is likely to be.
As a buyer, you hope that the overall value of the option will rise with time thereby enabling you to offset it at a higher premium so you can consolidate a profit.
Selling an options contract, on the other hand, is all about receiving the premium from the buyer of the option. When you sell an option, you receive the premium upfront and hope that the overall value of the option will plummet as time passes. That way, you can offset it at a lower premium thereby locking in the profits.
What is an Options Contract?
This is an agreement between an options seller and a buyer about the sale of an option. They agree on the price to pay i.e., the premium and the terms of reference with the goal being to facilitate a potential transaction.
Normally, the terms of an options contract have to be specific about the price at which it will be transacted (also known as the strike price) and the contract’s expiration date.
Although mostly used for hedging against inflation, options can also be used for speculative purposes. And the best part is that options cost a fraction of what the relevant shares would.
Therefore, by using this strategy you get to tap into a unique kind of leverage enabling you to take advantage of high-potential stocks without necessarily buying or selling them outright.
Call and Put Options
There are only two types of options: a call option and a put option. Let's look at each kind of option separately.
A call option
This is a contract between two parties, i.e., a buyer and a seller, where the buyer has the right but not the obligation to buy the underlying asset at a price that had been agreed upon (the strike price) within a specified period (contract expiration date).
A put option
A put option is a financial contract between a buyer and a seller giving the buyer the right but not the obligation to sell the underlying asset at the strike price within a specified period.
The Strategies: Bullish and Bearish
Now that we have covered all or most of the basics let's discuss the strategies. As a trader, You could be bullish or bearish, and we will explain the difference between the two below.
I) Bullish Strategies
You can be bullish by either buying a call option or selling a put option:
*Buying a call option
In most circumstances, call options are considered for a bullish view of the underlying asset by a certain degree.
A certain stock was trading at $90 per share on August 20, 2021. If you expect a price increase on this stock, you can purchase a $90 August call option for a $5 premium for every share. So, you will get the right to buy the stock at $90 per share but not an obligation to do so.
If your prediction is right and the stock registers an increase, there are two ways to go about the situation. The first thing is to sell the call option for a profit. Alternatively, you can buy the shares at $90 and sell them at the higher market price to profit from the difference.
However, you will also need to account for the premium paid to enter the contract. So, the actual profit will be the difference between the strike price and the market price minus the $5 you paid upfront.
To get the call option's breakeven price, you add the strike price to the cost of the call option (the premium paid for the call option). In our situation, it will be $90+$5=$95. If you believe that the stock will break above this price (breakeven), consider the call option a worthwhile investment.
*Selling a put option
Let's refer to our earlier example to explain why we consider selling a put option as a bullish strategy on the underlying stock. A stock was trading at $90 per share on August 20, 2021, and if your predictions say that the price will remain neutral or go higher, you go ahead and sell the $90 August put option for a $5 premium per share.
As a seller, you will get $5 per share, which gives you the obligation to purchase the shares from the buyer of the put option for $90 if you exercise the contract. If your prediction is accurate (the shares remaining at $90 or going higher), the put option will expire worthless while a $5 profit will be booked.
Another thing is that if you sell options, you can be profitable even if the stock moves in the opposite direction. You will only experience a loss if the stock goes below the $5 premium received.
Note that even if the stock were to move much higher, the profit would remain at $5. For this reason, we can conclude that you will find selling a put option useful if you have a bullish view but not too bullish.
If you are a trader with a very bullish outlook, it would be better if you bought a call rather than selling a put.
II) Bearish Strategies
Like with the bullish strategy, we shall use an example to explain everything.
*Buying a put option
We normally consider put options for a moderate or a strong bearish view on the underlying asset.
Let’s stick with the earlier example of a stock trading at $90 per share on August 20, 2021. If you expect the stock to fall and proceed to buy the $90 August put option for a $5 premium, you get the right but not the obligation to sell the stock at $90 per share.
If your prediction turns out accurate, i.e., the stock falls, there are two ways of going about this situation. You could either sell the option for a profit or buy the stock at a lower price and exercise the option at $90 to sell at a higher price.
You will also need to account for the premium that you paid upfront. So, the actual profit will be:
(Strike price-market price)-premium ($5)
From this illustration, we can say that buying a put option is being bearish to a certain amount.
We should also talk about the put option’s breakeven price, which is:
Strike price-cost of the put option ($5)
For the put option to be worthy of investing in, the stock should break below its breakeven price, i.e., $90-$5=$85.
*Selling a call option
The figures in this example remain the same as the others, i.e., a stock trading at $90 on August 20, 2021. If your expectations are that the price will stay neutral or go lower and you sell a $90 August call option for a $5 premium, you will instantly get the obligation to sell the shares to the buyer of the call for $90 if he chooses to exercise the contract.
If your forecast turns out right and the stock sticks at $90 or lower, the call option will expire worthless while a $5 profit will be booked.
Another advantage of selling call options is that you can be profitable even if the stock moves in the opposite direction. This is because this strategy only suffers a loss when the stock moves above the $5 premium received.
However, if the stock’s movement was significantly lower, the profit remains at $5. For this reason, selling a call option will only be useful if you have a bearish view that is slight but not too bearish.
All in all, if you have a very bearish outlook, you are better off buying a put rather than selling a call.
Benefits of buying options
What benefits do you get from buying options? They include:
*When buying options, you do not have to complete the trade. The implication is that if you make an inaccurate prediction regarding the price movement, your losses will not exceed the amount you paid for the options contract (the premium) and other trading fees.
*Purchasing options contracts does not require a hefty financial investment upfront. This is because an option contract costs significantly less than it would if you were buying the shares directly.
*With an option contract, you get a lot of trading flexibility as you have the freedom to employ different strategies before the contract expires.
Benefits of selling options
When it comes to selling options, several scenarios will highlight the benefits of doing so:
*Whenever the spot price rises above the strike price before expiry it gives you (the option buyer) the opportunity to earn some money.
*Next, at expiry, if the spot price is at or near the strike price, the option contract expires at the money. So, the seller will earn the premium because he placed a bet that the options price would plummet over time.
*Finally, if the spot price is below the strike price at expiry, the option contract expires out of the money. So, the seller will earn the premium as an income due to the option expiring worthless for the buyer.
However, selling options is a risky affair, especially if the market volatility is very high since there will be no exit strategy.
How call options work
Call options are derivative instruments due to their prices being derived from the price of an underlying security, e.g., a stock. For instance, if you buy the call option of IJK at a strike price of $125 and an expiration date set at November 30, you will have the right to buy 125 shares of the company before November 30 (expiry date) arrives.
Additionally, you may also sell the options contract to another buyer at any time before or on the expiry date at its (contract's) current market price. If the underlying security's price remains neutral or goes lower, the option's value will decline as the expiration approaches.
Uses of Call Options
You can use call options in the following ways:
I) Hedging Risks
Financial institutions such as investment banks often use call options as hedging instruments. When you hedge with an option opposite your position, it will help limit the number of losses on an underlying security in case of an unforeseen event.
You can buy a call option and use it to cushion yourself from the risk of any stocks you might have shorted or sell it to protect yourself against the potential risk of a pullback from any long stocks in your portfolio.
When you hold call options, you can gain some profits in case the price of an underlying security rises while you’ll only pay a portion of purchasing actual stock shares. We consider them leveraged investments since they offer limited losses (the cost of the option) and unlimited profits.
This high degree of leverage is why we consider call options high-risk investments.
Which One Is Better: Buying or Selling Options?
Since buying and selling options have pros and cons, we have yet to have a clear answer on the better strategy. The scenarios are as follows:
*Both parties (buyers and sellers) can exit their trades before the expiration date arrives. If the seller notices the premium moving in his favor or a position going against him, he can get out of his position.
Similarly, the buyer of an option can exit the trade if he notices that the premium of his position exceeds what he paid and wants a profit.
*As a buyer, your risk will be limited to the premium you paid. And as a seller, you can receive income (premium) upfront, and you will only incur costs if the spot price goes above the strike price. Even with that, the premium will still provide protection beyond the strike price.
*As a buyer, your ultimate goal is to make money, provided the option contract does not expire. However, your chances of making money dim as the expiration dates of the options approach.
On the other hand, even though a seller is often exposed to unlimited risk, it reduces as time goes by. This is because the individual assets have less time to move significantly in a particular direction.
When Should I Buy/Sell Options?
As you move from a novice to a more experienced options trader, your instincts will tell you when the right time to buy or sell your options. For instance, the most ideal time to purchase options is in low implied volatility environments. Additionally, you could also buy when you are anticipating a big upward or downward movement.
On the other hand, selling options will be best in a high volatility environment. The general rule is that higher volatility implies that the premiums available for collection will be higher.
Keep in mind that sideways or directional movements are the perfect situations for selling options. Always try to keep off stocks that are experiencing an upward or downward trend.
It would be helpful if you master the art of analyzing stock charts and you should count yourself lucky that there are software programs out there that could help you scan the best stocks for trading options on a particular day.
The choice between buying and selling options will depend on your preference as a trader. We have discussions that favor both sides; therefore, we cannot say whether being a buyer or a seller is more advantageous than the other.
However, it is advisable to base your decision on your risk appetite and objectives in terms of your targets as a trader.
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