From active speculation to risk management, buying and selling options can give traders ample flexibility in the market. However, unlike trading standardized futures products, trading options contracts requires a bit more skill and expertise. Let’s take a look at the mechanics of buying versus selling options contracts.
Buying Vs. Selling Options 101
Before making a direct comparison between buying and selling options, let’s get back to basics and explore what options contracts are.
What Is an Options Contract?
Simply put, an options contract is the right—but not the obligation—to buy or sell an underlying futures contract at a specified price. Options offer buyers and sellers tremendous strategic flexibility when engaging the world’s most popular asset classes. Commodities, stocks, currencies, and equities indices can all be traded using options.
Traders generally use options to earn income, hedge risk, and speculate on market conditions. Options are considered derivatives because they get their value from underlying assets. An option contract generally represents 100 shares of an underlying stock but can be written on virtually any type of asset.
Once a market participant has purchased an option, they’ll likely keep an eye on price movement. If the futures price increases, they can choose to exercise that option and assume a long futures contract, but they don’t have to.
Because this option has increased in value, traders can choose to offset it by selling back the same option and earning a profit. However, if the futures price dips below its original value, traders can allow it to simply expire, losing the money that was initially invested.
What Are the Pros and Cons of Selling Options?
Selling options is a great way to earn a profit—investors have access to the option’s premium up front, assuming the option expires with no value. Sellers take advantage of passing time and can carry out an offsetting trade at a premium with less value as the option’s value decreases. Unfortunately, selling options carries some risk, especially if market volatility is high because there’s no exit strategy.
In the live market, there’s a big difference between selling a futures contract and selling a call option. Becoming proficient at each requires a bit of education and due diligence. In the case of selling options, it’s important to understand how time, implied volatility, and pricing are related. By doing so, you can design more suitable options-writing strategies.
What Are the Pros and Cons of Buying Options
Buying options requires a smaller financial investment up front because options contracts cost significantly less than what a trader would be required to pay when directly purchasing shares.
Let’s say you want to take a long position in IBM stock. You have two choices: purchase the stock outright or buy a call option. As you can see below, there’s a big difference between the capital outlay required to execute each trade:
Buy stock: To take a conventional long position in IBM, you have to buy the stock For instance, to buy 100 shares of IBM, you would have to pay 100 times the stock price. If IBM stock is going for $125 per share, then you have to cover the $12,500 cost to open the position.
Call option: In lieu of buying IBM outright, you can assume a long position via buying call options. An option contract gives the holder the right to 100 shares; all that you pay is the premium. If you want the rights to 100 shares of IBM, buying one call option with a strike of $125 is like buying the stock outright. The only difference is the capital outlay (100 times the premium) and the contract expiration date.
Additionally, anyone who purchases options isn’t required to complete a trade. If your predictions regarding a stock’s price movement within a specific time frame are incorrect, your losses only include the amount you paid for the options contracts and applicable trading fees. Options contracts also provide trading flexibility because traders can employ many strategies before an options contract expires.
Buying Calls and Puts
No matter what product you’re trading, buying and selling are typically the two most fundamental aspects involved. In most markets, when a buy order is carried out, a new long position is opened. When a sale takes place, either an existing long is closed or a new short position is created at market. These actions are an essential part of the futures, currency, and equity trades.
When compared to more traditional securities, the functionality of options is somewhat unique. Though it may be true that buying and selling options contracts are basic functions of active trading, each can be accomplished in multiple types of ways using call and put options. Here is a quick breakdown of each action:
Calls: The buyer of a call option has the right to purchase a contract’s underlying assets at a specified price (i.e., strike price) on or before a future date.
Puts: The buyer of a put option has the right to sell a contract’s underlying assets at a specific price on or before a date in the future.
When you buy a call or put option, the premium refers to the price paid for the opportunity to execute the contract according to its specifications. The premium is the liability assumed by the trader: If a beneficial move in price deems a contract “in the money,” a financial gain may be secured only after the premium is exceeded.
Strategies for buying calls and puts may be developed to favor either the bullish or bearish side of the market. For example, when you buy a call option, you open a long position and profits are realized from price appreciation. If you buy a put, you assume a bearish market stance with gains banked from falling asset prices.
Selling Calls and Puts
In contrast to buying calls and puts, selling options is considered somewhat counterintuitive. Instead of paying the contract’s premium for the right to buy or sell at some future point in time, you collect the premium up front and are “assigned” the obligation to sell a product, if exercised. This distinction is important because liabilities of uncovered positions can potentially be unlimited.
When you sell or “write” an options contract, any number of strategies may be put into play using calls and puts. Here are a few:
Calls: Selling call options is one way investors insulate long-term positions from short-term drawdowns in value. By selling a call, falling asset prices ensure that the premium is realized as profit. These types of strategies will favor a bearish market bias and are commonly executed in the equities markets.
Puts: When a trader sells a put option, a bullish position is essentially opened in the market. This contract represents an obligation to buy at the distinct strike price at some point before its expiration date. Thus, if asset values hold firm above strike, the contract expires worthless, and the premium becomes realized profit.
As you can see, there’s a bit of nuance involved in the buy versus sell call options and put options dynamics. Although buying calls and puts is great for gaining direct market exposure, selling can also be profitable. Ultimately, the responsibility falls on the trader to decide whether to buy or sell options contracts.
Is It Better to Buy or Sell Options?
It’s no secret that market participants selling options typically outperform buyers at a nearly 60/40 clip. The odds favor the party that writes the contract because of the concept of time decay.
Options contracts are considered perishable securities because they have an expiration date. As time passes, the chances for “out of the money” positions to expire worthless increases.
In addition, periods of low implied volatility can hamper the odds of significant pricing variations above and below strike. This is an important element of options contracts and another that favors the seller. Accordingly, implied volatility is a key factor in the buying versus selling options dichotomy. If you anticipate high implied volatility, it may be better to buy options rather than sell. In the case of low implied volatility, selling calls and puts may be a superior strategy.
So, if the chances of success are skewed in favor of the contract writer, why doesn’t everyone sell options? Risk.
Most traders want to avoid potential losses and wasted time. Upon writing an option, the seller is assuming what could be unlimited potential losses. If not properly covered by separate market positions, periods of high market volatility or untimely black swan events can cause catastrophic losses. This was the driving force behind the $150 million meltdown of optionsellers.com during the natural gas rally that took place in fall of 2018.
It’s generally advised to buy options contracts when market volatility is expected to increase and sell options when volatility is expected to decrease. By doing so, you can either directly profit from market swings or gain the premium paid for writing the contract.
Is Selling Options Contracts the Right Strategy for Me?
Are you still confused about the question of whether to buy versus sell call options and put options? Want to know more about buying versus selling options? Perhaps a bit of education is in order!
Before diving into the options markets headfirst, it’s essential to become familiar with the basics. A great way to learn the ins and outs of options is to take the free StoneX online “Options Strategies” course. It will get up to speed on strategies such as covered calls, married puts, and spreads. Don’t wait—expand your knowledge of options today.
This blog was originally published September 25, 2019 and has been updated for accuracy and comprehensiveness.