This is one thing that I have noticed with new traders and even those with more experience. It’s not always clear to traders when to be buying options and when to be selling them. In this article, I’m going to guide you through the key differences between buying vs selling options.
I’m writing this specifically so that new options traders can grasp these concepts. For the more experienced traders, bear with me, I think you’ll find this is a nice refresher on the subject. Let’s get to it!
The Key Differences Between Buying Vs Selling Options
We’ll start by reviewing some of the basics of options trading. Most traders I know start out with buying options.
We know that when we buy a put or call option, it gives us the right but not the obligation to buy or sell the underlying security at a specified price. This price is called the strike price and is accompanied by an expiration date for the contract.
Buying options contracts is considered a debit, since you are paying up front for the contract. The amount you pay is called the premium and the value of this changes due to a number of different elements. These include the price of the underlying stock and the time decay as the contract moves towards expiry.
When we sell options, you have either the obligation to buy or sell the underlying security at the strike price. Selling options is considered a credit, since you are receiving the premium paid by the buyer of the option. You can sell both put and call contracts for stocks and ETFs.
Here’s a great little table that I’ve made to remember the differences between buying and selling options:
Brand New To Options? Read This Article First: What Is The Option Chain and Why Is It Important?
What Is An Options Contract?
Before I dive into some strategies for buying and selling options, I want to make sure we’re all on the same page.
What exactly is an option contract? An option contract is a derivative of an asset like a stock or ETF. It provides a trader with leverage with a fixed amount of risk.
Each option contract, whether it is a put or a call, represents control of 100 shares of the underlying asset. One of the advantages of trading options is that it provides exposure to assets at a fraction of the cost. For example, buying 10 options contracts costs much less than buying 1000 shares of the stock.
This is especially beneficial for those with smaller accounts. As most beginners have to start somewhere, trading options can be a faster way of building up your trading account.
What Are Call Options & Put Options?
So you’ve already heard me refer to calls and puts a few times now. Before I explain a bit about how to trade them, I want to make sure you know what they are. These are the only two types of options for stocks, so it’s critical that you understand how they work before you trade them.
- A Call Option is a financial contract between a buyer and a seller, giving the buyer the right but not the obligation 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 but not the obligation to sell the underlying asset at the agreed-upon (strike price) within a specified period of time (contract expiration date).
Buying Call & Put Options
As I mentioned, I find that most new traders start off by buying options. This makes sense because it is simply an easier concept to understand.
When buying call options, you profit from the upward movement in the price of the underlying asset.
Alternatively, when you buy options, you profit from the downward movement in the price of the underlying asset.
As an option buyer, you have something called Theta Decay working against you. As time goes by, a small amount of the option’s value erodes or decays. If you look at your options positions, you’ll notice that the value of the option will often decline as it approaches its expiration date.
My tip for new options traders: Consider giving yourself at least 30 days before expiration. You’ll also want to avoid Out-Of-The-Money (OTM) options. Over the long run, you’ll find that this increases the chance of your option trades ending up profitable.
Now that we have the basics out of the way, let’s talk strategies!
Buying Calls: Bullish Strategy
Here’s an easy example I like to use to explain buying call options:
If you are bullish on the S&P 500 index over the next month, you’d be looking to buy a call for the SPY ETF. If your analysis was accurate, then you’ll profit from the upward movement of the index. The call option would gain in value as the price of the SPY ETF increased.
Simple right? Buying call options is the simplest strategy. Naturally, most traders tend to start off as bulls and only picture the stock prices rising. Let’s move on to a more bearish strategy.
Buying Puts: Bearish Strategy
Here’s another easy example to explain buying put options:
So let’s say you’re bearish on a stock or company over the next month. Let’s say it’s Apple (AAPL). So you could buy a put option against the Apple stock to profit off of the potential downward movement. If your analysis was correct, then the value of your put option will increase as the stock price of AAPL declines.
Again, fairly straightforward. Let’s move on to selling options which is a completely different world.
Selling Call & Put Options
You know, there’s a popular saying amongst experienced options traders:
“Options Were Meant to be Sold”
Do I believe this? Absolutely. If you have read my other articles or followed along with my videos, you’ll know I love selling options. I like to trade using the Wheel Strategy, which begins by selling put options.
You see for a majority of the time, markets tend to chop and move sideways. Now, over time markets do tend to trend in an upwards direction. But with options, we have a shorter time horizon.
Options sellers can profit in any market, whether it is moving up or down. In fact, we can profit in a sideways market too. No matter what the market is doing, selling options can be a great way to trade.
When you are an option seller, you’re also referred to as the Option Writer. You get to set the parameters of the trade including the strike price and the expiration date.
When writing options, you also get to collect the premium up front. No matter what happens to the trade at the time of expiration, you’ll always keep the premium.
One of the ways to capture a high upside is to write what is called a Vertical Spread. This happens when you sell a call option and then buy a call option for the same asset. Both contracts have the same expiration date but different strike prices.
If you sell a call or put option without also buying one, it is called selling naked. Meaning, you do not have another option contract or the underlying shares as collateral in case you get assigned. This can be seen as a riskier option strategy and should be left to experienced traders.
Selling Calls: Neutral To Bearish Strategy
Selling call options is slightly bearish. You have the obligation to sell the buyer of the contract the underlying shares at the strike price. This only matters if the buyer exercises the contract.
Now, as far as I have been trading options, this is actually a pretty rare circumstance. It is something to be aware of though when selling call options. To profit from selling call options the writer is hoping for sideways to downward movement.
From our example above, if you are bearish on AAPL then you can also sell calls on the stock. If AAPL is trading at $150.00 and you sell the $150.00 call option, you are hoping that the stock does not close above $150.00 on the expiration date. This is why it is a neutral to bearish strategy.
One thing to note: Selling naked call options has the potential for unlimited risk. If the stock price of AAPL surges higher, there’s quite literally no ceiling for how high it can go. This can be a very costly mistake for your trading account.
Selling Puts: Neutral To Bullish Strategy
Okay so if selling calls is a bearish strategy, then the opposite is true for selling puts. This gives you the obligation to buy shares at the strike price if the buyer of the contract exercises it. Again, this is rare, but it can happen. Be prepared to pay from your trading account for those shares.
If you’re bullish on AAPL at $150.00 per share. You can sell the $150 strike AAPL Put and collect premium from the buyer of the contract. You would make money as long as AAPL stays above the strike price of the contract.
When To Buy and When To Sell Options?
As you gain more experience with trading options, you’ll get a feel for when to buy or sell them. Buying options is most favorable in low implied volatility environments or when expecting a big move up or down.
Selling options is much more favorable in a high volatility environment. Higher volatility means higher premiums to collect. If a stock is at the end of a trend, it is a great time to sell options against it.
Remember, you want directional and sideways movements when selling options. Try to avoid stocks that are in the middle of an upwards or downwards trend.
Learn to read the markets and analyze stock charts. This will become one of your most valuable tools as a trader. I also recommend checking out the PowerX Optimizer software which can provide a scan of the best stocks to trade options for on a given trading day.
Conclusion: Buying Options Vs Selling Options
When I think about options, I always think about the saying “there’s more than one way to skin a cat.” It might be a graphic saying, but the metaphor certainly applies to options trading.
At first glance, you might think options trading is simple because there are only calls and puts. As you dive deeper you’ll find a multitude of different strategies you can use. Debit spreads, credit spreads, iron condors, butterflies, diagonals, the list goes on.
The point is, there are countless option strategies to learn. They all have their advantages and disadvantages. But they also all involve the basics of buying and selling calls and puts.
I hope this helped you learn a bit more about the differences between buying vs selling options.