What Is An Option?
An option is an agreement or contract between two individuals: the holder and the writer. When it comes to the stock market, writers are also referred to as sellers, and holders are buyers.
An option holder has the right, but not the obligation, to purchase or sell an asset at a determined price, either on or before the specific date. In order to lease this right to the holder, an option writer gets something called a premium. Premiums are just a sum paid to the writer, essentially acting as their fee.
Quick Facts
- Option Buyer = Holder
- The right to purchase or sell underlying assets at a particular price
- Options Seller = Writer
- The obligation to purchase or sell underlying assets if any contracts are assigned
Buying Vs. Selling
In the stock market, there are sellers, or there are speculators who hope for a significant price jump in the option they just bought.
Sellers write options because they understand options can expire and become worthless. This allows them to keep most or all of the premium in most circumstances. Sellers make steady, predictable earnings, while speculators have portfolios that are full of losses.
Selling Options
Selling options can be similar to operating a stock market insurance company. You will be underwriting risk for a premium, just like insurance companies do require premiums from their clients. They do this because they’ve seen the data and discovered that there’s a positive expectation of their work, so paying a few high claims is just part of the package.
Buying options can be a losing proposition, leaving you to pay a high premium to secure a position within financial markets. So generally, participating on the flip side of that bet becomes a winning proposition.
Selling options can be very similar to casinos. They have a well-defined edge to their games. Casinos understand their expectation, and in the meantime, they take some losses, sometimes large ones, sometimes high rollers will take them for a few million, but they always know how their bottom line looks.
Time Decay
Options are like grocery store produce. They have limited shelf lives, with a daily diminishing value. Stores are constantly marking down overripe produce or foods nearing their expiration dates. This also relates to options. Options continually lose value the closer they get to their expiration. This is called time decay.
Options sellers are putting time decay in their favor, just like selling browning bananas!
Pros
Stable Returns: One of the most predictable sources of returns in the market is selling premium. These premium-selling strategies frequently have a high success rate and provide a great way to grow your trading account swiftly. Naturally, this comes with a caveat that losses can potentially outsize any winning trades.
Implied Volatility Is Generally Amplified – The VIX is often referred to as the “fear index” of the stock market. Understanding the VIX more in-depth allows you to see how it regularly projects a much darker view of prospects than what actually happens.
The VIX essentially measures the implied volatility of SPX options. It often casts dark representations of the future because implied volatility is generally exaggerated. Option sellers take advantage of this happening by selling options with high levels of implied volatility.
Suitable For Trading Psychology – Traders often benefit from systems that projects them winning high percentages of trades. This gives them a feeling of self-confidence, with less second-guessing and tweaking.
Cons
No BIG Trades – Big home run trades just around the corner usually keeps some traders persevering for that big break. Unfortunately, this opportunity doesn’t come as an option seller.
Return distributions buying and selling options is similar to mean reversion and trend following trading systems.
Mean reversion system returns are commonly focused around the mean, which generates numerous small wins. The fat tail on the left represents the seldom catastrophic losses that occur. Trend following has a much lower success rate, with small losses and generous wins.
Possible Catastrophic Losses – Nothing is ever free. Strategies with a smooth equity curve like premium-selling always have considerable drawbacks. The possibility of catastrophic losses is the biggest drawback for premium selling. OptionSellers.com, experienced this when they lost all of its client’s funds, forcing several into debt to clearing firms.
Won’t Get You Wealthy – Buying options is a constant uphill battle, but the advantage is that buying the right option could actually multiply your account overnight. Traders often buy an OTM call and suddenly get lucky. In this case, however, there isn’t a chance of waking up in the morning only to notice the calls you bought for just pennies traded for $20 by selling options. Your max reward is set going in, and this becomes the total premium collected.
Closing Thoughts
Have you heard the term “picking up pennies in front of a steamroller?” Selling premium often feels like that, particularly in unfamiliar or evolving market conditions. But, just as you know, nothing comes free. Strategies with significant structural advantages always have their drawbacks.
To review, premium selling is generating that smooth equity curve, with an infrequent large loss. The return distribution is comparable to numerous mean reversion stock trading systems.
