One thing I continuously see with beginners, or even those who’ve been trading for over a year, is that they struggle to understand when they should be buying options vs selling options. In this article, I’ll break down and guide you through the key differences between buying options and selling them in an easy to grasp way for new options traders.
The Key Differences Between Buying Options vs Selling Options
When buying options, you have either the right to buy or sell the underlying security at a specified price (the strike price), dependent on whether Calls or Puts were purchased. Buying options is considered a ‘debit’ since you’re paying upfront for the contract.
When selling options, you have either the obligation to buy or sell the underlying security at a specified price (the strike price), once again dependent on if Calls or Puts were purchased. When selling options, you’re receiving a ‘credit’ in the form of the premium for the contract(s) you sold.
There are two key concepts to take away when buying options or selling options. First, when buying options you have the right to buy or sell the shares of the underlying security. Also, when buying options you’re paying upfront which is considered a debit. When selling options, you have the obligation to buy or sell shares of the underlying security. When you’re the option writer (selling options) you’re collecting a fee for selling that contract, referred to as a ‘credit’.
Brand New To Options? Read This Article First: What Is The Option Chain?
What Is An Options Contract?
An Option Contract is a derivative of a Stock, ETF or even Futures product. An Option Contract gives a trader leverage similar to a futures contract, but unlike them, an option contract has a multitude of ways to be traded with fixed risk.
A single Option Contract represents the control of 100 shares of the underlying asset at a fraction of the cost.
For smaller accounts, the leverage of options provides a great way to quickly grow a small account.
What Are Call Options & Put Options?
Calls and Puts are the fundamental building blocks of any options contract.
- Call Options: A Call Option is a financial contract between a buyer and a seller, giving the buyer the right (or option) to buy the underlying asset at the agreed-upon price (strike price) within a specified time (contract expiration date).
- Put Options: A Put Option is a financial contract between a buyer and a seller, giving the buyer the right (or option) to sell the underlying asset at the agreed-upon (strike price) within a specified period of time (contract expiration date).
Buying Call & Put Options
Buying options is a much easier concept for newer traders to wrap their heads around. When buying Call Options, you’re profiting from upward movement in the underlying asset. When buying Put Options, you’re profiting from downward movement in the underlying asset.
A the option buyer, Theta Decay is working against you. This means that with each day that passes, a small amount of the options’ value erodes or ‘decays’.
For newer options traders, you should consider giving yourself at least 30 days before expiration and don’t buy Out-Of-The-Money (OTM) options. By doing this, you’ll give yourself a far greater chance of your options ending up profitable.
Buying Calls: Bullish Strategy
Example: If you are bullish the S&P 500 over the next month, you could buy a Call Option in the ETF:SPY, to capitalize from the upward movement. If your analysis was correct, your option contract would gain value as the ETF price increased.
Buying Puts: Bearish Strategy
Example: Let’s say you believe Apple’s stock price is going to fall over the next month. You could buy a Put Option to take advantage of the downward movement in price. If you were correct and price moves lower, your Put Option would increase in value.
Selling Call & Put Options
There’s a popular saying in the options world:
“Options Were Meant To Be Sold.”
This is because the majority of the time, stocks and the market tend to chop or move sideways. Timing the next big uptrend or downtrend can be difficult and requires precision when buying options. As an option seller, you can not only profit from upward or downward movement but also sideways movement in the underlying security.
When selling Calls or Puts, you are what is referred to as the ‘Option Writer’.
When selling options, you benefit from the premium decay (or Theta Decay) created by the passing of time. Premium is the fee or credit you collect for being the option writer.
If you sell a Call Option and Buy a Call Option this creates a Vertical Spread. Vertical Spreads produce a fixed risk and fixed profit strategy. Selling a Call or Put, without also buying a Call or Put, is known as ‘selling naked’. This is because you have no protection or cover if you’re wrong in direction and the underlying moves against you. Only the most experienced options traders should consider selling options naked.
Selling Calls: Neutral To Bearish Strategy
As a Call Option writer, you have the obligation to sell the buyer of the contract the underlying shares at the strike price, if they were to exercise the contract. This is an incredibly rare circumstance, but something to be aware of when selling Call options. Selling Calls is a neutral to bearish strategy. This means, that with sideways to downward movement in the option, the option-writer makes money.
Example: Say you’re bearish the S&P 500. The ETF for the S&P is SPY and it’s currently trading at $200/share. You can Sell a 200 Strike SPY Call Option, collecting the credit or premium from the person buying the 200 SPY Call Option. You would make money with downward or sideways movement in the S&P.
Note, that selling naked Call Options has the potential for unlimited risk. From our example, if your analysis is wrong and the S&P rallies, there’s no ceiling for how high it can go.
Selling Puts: Neutral To Bullish Strategy
As a Put Option writer, you have the obligation to buy shares at the strike price of the contract, if the Put buyer chooses to exercise the contract. As mentioned before, this is very rare and isn’t an issue if you’re not holding the last week of the contract’s expiration.
Example: Say you’re bullish the S&P 500. The ETF for the S&P is SPY and it’s currently trading at $200/share. You can Sell a 200 Strike SPY Put Option, collecting premium from the person buying the 200 SPY Put Option. You would make money with upward or sideways movement in the S&P.
When To Buy and When To Sell Options?
Experienced options traders know how to identify when it’s best to buy options vs selling options. Buying options is most favorable in low Implied Volatility(IV) environments and when you’re expecting a big move up (with call options) or down (with put options) from the underlying asset. When selling options, it’s more favorable to sell options in a high IV environment. If a stock has recently had a big move and is no longer in a trend, this can be a great time to sell options. Remember when selling options, you can make money from directional and sideways movement.
Conclusion: Buying Options vs Selling Options
The saying, “There’s more than one way to skin a cat.” couldn’t be more true for trading options. The further you dive into options trading, you’ll find a multitude of different strategies to both buy and sell options: Debit Spreads, Credit Spreads, Iron Condors, Butterflies, Diagonals… the list could go on for quite a while. The point is, there’s a TON of different options strategies all with their own unique advantages and disadvantages. Now that you understand the basic differences between buying options vs selling options, you can start to dive into the multitude of ways to do so.