Introduction to Options
Every options contract has two sides–the buyer and the writer.
You’re likely familiar with how buying an option works.
You buy the right, but not the obligation to buy or sell a stock by a specified date, at a specified price. But someone has to sell that right, and that’s the option “writer.”
You see, the option writer takes the opposite side of an options trade. You pay them a “premium” (which is the price of the option), which they get to keep for taking on the risk.
Should the option expire worthless (i.e., calls expire below the strike price and puts expire above the strike price), their profit is the entire premium.
Let’s create a hypothetical options trade to illustrate this concept. You buy an XYZ call option at a strike price of $10, which expires in two days and pay $1 for the option.
The option writer takes the other side of this trade and sells the option to you.
They immediately collect the $1 in their trading account. Two days pass, and the XYZ is still trading at $9 when the option expires. Your option is now worthless, and the option writer keeps their $1 profit.
You buy an ABC call option at a strike price of $100, which expires in four days, and you pay $5 for the option. The option writer collects that $5 as soon as the transaction occurs.
At option expiration four days later, ABC is trading at $150. Your profit is now $45 (the $50 in excess of the strike price minus your $5 premium paid), and the option writer lost $45 on the trade.
One thing to note is that standard stock options are blocks of 100 shares. So, when you buy an option for $2.00 in premium, you have to multiply that by 100.
The Profitability of Shorting Options
Shorting, selling to open, or writing an option all refer to the same thing. You’re shorting the option, meaning that you’re taking the opposite side of the bet that the option buyer is taking.
As such, your maximum loss when shorting an option contract is the same as the option buyer’s maximum gain for the equivalent contract.
For example, let’s review the profitability of a call option contract that costs $2.00 at a $50 strike price for both an option buyer and an option seller:
- Maximum gain: unlimited: there’s no limit to how high a stock price can go.
- Maximum loss: the price you paid for the option (in this case, $2.00). This is also known as the premium.
- Maximum gain: the price you sold the option for (in this case, $2.00). This is also known as the premium.
- Maximum loss: unlimited: there’s no limit to how high a stock price can go.
Notice how the profitability of the option buyer and seller are just flipped? It’s easy to grasp when viewed in this context.
Keep in mind that put options are slightly different. Here’s an example for a put option contract that costs $2.00 at a $50 strike price for both an option buyer and an option seller:
- Maximum gain: The lowest a stock price can go is zero, so to get the max profit on a put option, you have to subtract the premium paid from the strike price. In this case it would be $50 – $2 = $48. To get your profit in dollars, just multiply this by $48 * 100 = $4,800.
- Maximum loss: the precise you paid for the option (premium). In this case, it’s $2.00 * 100 = $200
- Maximum gain: the price you sold the option for (premium)
- Maximum loss: $4,800, the same as the option buyer’s maximum gain
Shorting Calls vs. Shorting Puts
Two significant factors differentiate shorting calls, and shorting puts. When you short a call, your theoretical risk is unlimited.
In the unlikely scenario that you’re a short a call on a stock that rises tenfold overnight, you’re on the hook for that.
On the other hand, your losses when shorting puts are capped to the price of the stock. If you short a put on a $10 stock, the most you can lose is $10 minus the premium you collect.
While this may seem like a trivial difference, it makes a huge difference when you can be absolutely certain of your maximum risk.
Selling Options In Spreads
Selling naked premium is a sound strategy if applied correctly. It’s part of the way Marty “Pit Bull” Schwartz trades nowadays.
However, as mentioned, just shorting options can leave you open to massive gap risk.
One way to mitigate this uncapped risk is to hedge the position by buying or selling offsetting options.
These are called ‘spreads,’ and they’re by far the most confusing concept to most newbie option traders, but they’re simple when you strip away the jargon.
In the Profitability of Shorting Options section of this article, we explained the payoff of buying or shorting an option. What if you bought and sold the same option at the same time? The positions would offset each other.
But what if you changed the strike price on the option you bought? Then, you would only be risking the difference between the two strike prices.
Creating options spreads can be as complicated or straightforward as you’d like. The main objective of creating spreads is creating payoffs that can’t be achieved by buying or shorting outright options or stock.
By combining the payoffs of different options, you can create a trade to profit from more than just directional price movement, but increases or decreases of volatility, the passage of time, or the stock price falling to deviate from a price range.
Selling Options: Not So “Secret” Income
If you’ve consumed a decent amount of trading content, you’ve probably encountered several ads selling you on a “secret” method to generate trading income.
Almost every time without fail, these ads are referring to selling options.
It’s a very easy strategy to sell because selling options have a very high win rate (often higher than 90%). Equity curves are smooth, and wins are frequent. The problem is that it’s probably the easiest way to blow up your account.
Laying Odds vs. Taking Odds
While selling options premium is a sound strategy used by many of history’s great traders, you should be skeptical of marketing hype. “Becoming the casino” is one of the most common pitches to sell premium-selling programs.
This is because, most of the time, when you sell an option, you’re “laying odds” instead of “taking odds,” in gambling terms.
When you lay odds, your payout is smaller than your initial wager. If your payout is only $50 on a $100 wager (indicating 75% odds in your favor), you’re “laying odds.”
When you take odds, your payout is larger than your initial wager. If your payout is $100 on a $10 wager (indicating 10% odds), you’re taking odds.
Trading with a high win-rate may be right for some traders’ mindsets. That’s what’s great about modern financial markets. With so many unique instruments available, you can structure trades with nearly any win-rate or payout, so long as you’re taking or laying the appropriate odds.
But, there’s nothing inherently special about laying odds.
Yes, your win-rate will be higher, but your gains will be smaller while your losses will be larger. It’s the reverse of the trend-following style of trading, where you have lots of small losses and less frequent large wins.
In our example above, we showed how one bad breakout or gap could deal you a devastating loss in option selling.
As a naked option seller, you’re always net-short, meaning your theoretical risk is very large (in the case of puts) or unlimited (in the case of calls).
You should know by now that there are no free lunches in financial markets. Although, you can find coupons sometimes.
The Best Market Environment For Selling Premium
Premium sellers love a market that “goes everywhere to go nowhere,” when the market bounces around in a wide-range but never chooses a direction.
This type of market results in premium being very expensive while most of it expires worthless.
When volatility is high, the market needs to make larger moves for premium buyers to profit. If the market remains range-bound despite the volatility, premium sellers are raking it in.
This brings us to the implied volatility. Implied volatility refers to how much volatility options traders are pricing into options prices.
When traders expect big price moves, like before an earnings report, implied volatility is high, and vice versa.
When implied volatility is high, options are expensive, and the underlying stock needs to make a large price move for you to profit when buying options. This allows option sellers to collect huge premiums.
As a general rule, option buyers aim to buy when implied volatility is low because options are cheap, and option sellers desire to sell when IV is high because premiums are high.
Options allow you to craft a position to profit from more than just a directional movement in the underlying stock.
You can profit from the passage of time, an increase or decrease in volatility, a stock remaining in a range, etc.
However, to craft these more nuanced positions, you need to create an options spread and get comfortable combining short and long options together.
In many cases, using a short option can offset the cost of buying an option outright.
Credit: Warrior Trading