Let us discuss about the differences between option buying and option selling in this video.
When you are trading options, you can either buy or sell an option contract. You may be wondering, which is better? Buying or selling options? In this video, we are going to explain the facts of selling options and buying options.
So, let’s start with some basic explanations.
An Option buying means, having the right to buy or sell the asset as a predetermined date and price, by paying a small amount of premium, whereas an option selling means, having an obligation of buying or selling assets at a predefined date and price. 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 lapses, so that the premium becomes 0. 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 price of an option, but the primary 3 factors are time to expiration, price movement, that is the direction of the underlying stock relative to the strike price, and volatility.
Let us throw some more light on this, as to why selling options gives you a higher probability of winning.
The first thing is, that the 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 and its volatility, remain the same, that option will be worthless at expiration.
Time decay always works in the favour of the option seller and against the option buyer.
The second thing to note is that, at any point of time, the stock price can move in 3 directions: Up, down, or it can remain constant at that level. 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 down, 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 the option seller. Options selling is also more popularly known as Option Writing. Now, once you have entered into this trade, the stock price can move in any direction, means 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 Rs. 520 call option for an underlying stock, currently at Rs. 500, and took in Rs. 10 as the options premium, the following could occur, as shown on the screen:
As it can be seen in the Table, 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 a profit, only if the underlying price goes above the strike price, plus the premium paid.
To conclude, I would say that when you are buying an option, there are two things which need to work in your favour. First is the stock direction, and second is the volatility. If the volatility of the underlying stock doesn’t increase, the premium value decreases, and the option buyer faces losses.
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