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Basics Of Options

Option Buying Vs Option Selling

Next, in this section, we will discuss the differences between Options Buying and Options Selling

 

When you are trading options, you can either buy or sell option contracts. You may be wondering, which is better?  Buying or selling options?  Let us understand the nitty-gritties of selling and buying options.

 

When you buy an option there is someone selling it to you and vice-versa. Now suppose you are a seller of an option; you collect the option premium (at the time of executing the trade) from the option buyer. Your goal is to buy it back at a lower price, or the contract lapse so that the premium becomes zero. The buyer’s goal is to sell it at a higher premium than what was paid to enter the transaction.

 

There are several factors that affect the price of an option, but the primary three factors are time to expiration, price movement that is the direction of the underlying stock relative to the strike price, and volatility.

 

Now it has been seen that a seller of an option has 2/3rd chance of making profit where as a buyer of an option has only 1/3rd chance of making profit. 

 

Why does selling options give you a higher probability of winning?

 

1st thing is - Time Decay is always in the favour of the Option Seller.

 

Options are a decaying asset.  The premiums decay with the passage of time and they expire.  So even if all the other factors that affect an option’s premium price, such as the price of the underlying stock, its volatility remain the same, that option will be worthless at expiration.  

 

Time decay always works in favour of the option seller and against the option buyer. 

 

2nd thing to note is that at any point of time the stock price can move in 3 directions: Up, down, or sideways. When you sell options, you can be in a profitable position when the price moves in the direction which you want it to move , or if it moves sideways, and  even slightly in an undesirable direction.

 

Let’s take a look at an example by selling a call option.  When you sell a call option, you normally sell a contract with a strike price that is higher than the current stock price.  By entering in this trade, you collect the premium as being the option seller.  Now once you have entered into this trade, the stock price can move in any direction, meaning the stock can either go down, it can remain unchanged, or it can go up by a little to be in a winning situation. 

 

If you sold a ₹ 520 call option for underlying stock currently at ₹ 500 and took in ₹10 as option premium, the following could occur:

 

 

As it can be seen in the Table above, the option seller earns as long as the underlying price is below the strike price plus the premium received by him. The option buyer earns or is in profits only if the underlying price goes above the strike price, plus the premium paid.

 

When you are buying an option, there are two things which need to work in your favour. 1st is stock direction, and 2nd is volatility. If the volatility of the underlying doesn’t increase the premium value decreases, and option buyers face losses. 

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Units 9/20