Selling vs Buying Options: Why Sellers Have the Edge

It’s very difficult for me to believe that buying and selling options fall under the same umbrella term of “options trading.” In my first blog post, I already confessed that the very concept that got me hooked to the options world is the fact that — as an option seller — you naturally have a statistical edge in the market. And that of course comes at a price that has to be paid by the option buyer!

Why would you ask? Well, because buying and selling options are two completely different games, with different rules, purposes and strategies :) But before diving in, let’s have a refresher on what an option actually is:

An option is a financial derivative that gives the buyer the right, but not the obligation, to buy or sell (call/put) an underlying asset at a specific price on (or before) a specific date.

The Game of Buying Options

If the above definition sounds a bit abstract, here is a clear example:

• Bob owns 100 shares of Acme Inc and fears that the stock may crash
• Acme Inc is currently trading at $100 per share, but Bob bought years ago at $60 — he already made a nice profit
• Bob wants peace of mind to lock in his profit at $90 per share, so he buys a Put Option from Alice, for $1.50 per share

At this point, a few things may happen:

1. Acme Inc keeps rising — Alice keeps the premium Bob paid as “insurance” against a crash
2. Acme Inc falls but stays above $90 (the strike price) — same as above, Alice keeps the premium
3. Acme Inc crashes — Bob has the right (but not the obligation) to exercise his Put Option and sell his shares for $90, protecting his investment and locking in his accumulated profit

This is of course a simplified example, but a meaningful one for understanding the rationale behind buying put options. Options can act as an insurance policy for your shares or assets, but they’re also used for:

• Speculation: you can buy a put betting on a price crash to cash in the difference, or a call to make a similar bet on a price increase.
• Hedging: similar to the example above, options can protect your portfolio from adverse price movements.
• Advanced usage: leverage, arbitrage, risk management and other more sophisticated purposes.

The interesting fact is that, like the majority of insurance policies against illness, hurricanes and car crashes, options are rarely exercised. When they are, it’s a big payout — but the frequency is contained (depending on a few factors, of course). With options it’s pretty much the same. To borrow a nice metaphor from The Unlucky Investor’s Guide to Options Trading: buying options is like playing slot machines, selling options is like owning the slot machines.

And this brings us to the other side of the table:

The Game of Selling Options

In the above example, Alice sold a Put Option for $1.50 per share — but how can she sell something she doesn’t own? Bob was the one holding the shares!

She sold a cash-secured put, meaning that — until the option’s expiration date — she has to commit the capital of $90 per share in her brokerage account to be able to “deliver” the shares if the contract gets exercised. It’s not the only way to do it, as there are strategies that allow you to operate on margin, but let’s keep it simple for now.

The reason Alice was able to calibrate the risk and essentially control her chances of being profitable is that the strike price of $90 and the expiration date (say, 25 days out) were chosen by her. She could have sold at a strike of $85, collecting less premium but increasing her chances of success — or gone further out in time, collecting a higher premium but being exposed to more market events that could influence the price.

Alice set the terms of this trade. Bob agreed and bought.

There are many things you can do as an option seller to maximise your chances of profit and trade in a way that fits your risk tolerance — and there are metrics (the Greeks) that allow you to quickly understand what you’re facing in a trade.

One of the most useful is delta (∆). In practice, delta is widely used as a rough proxy for the probability of an option expiring in the money. A put with a delta of -0.15 has roughly an 85% chance of expiring worthless — which means an 85% probability of profit for the seller at current market conditions. Alice could look at that number before pulling the trigger and decide whether the odds suit her. That is a simplified view of it, and there is much more to explore, but it gives you a sense of the edge you’re working with as a seller.

At this point I think it’s pretty clear which game I’m playing, and the one I believe you should consider too :)

Happy Investing,

Francesco