Option trading can be a risky game, but there are certain strategies that can give returns in normal market conditions. You can earn profits from option buying or selling when the market moves in your expected direction.
In option buying or trading in naked option, if the price does not move in the direction as per your expectation, then you might end up losing your premium. Or else, if the price moves marginally, the premium decay might make it hard for you to only break even. Here you can go for option selling, which is a better option in such market conditions.
What is an Option Selling Strategy?
In case of a buyer, to complete a transaction, there need to be a party on other side of the trade willing to sell the underlying at price determined. Option selling is the trading activity in which a trader sells an option contract for specific strike price at an agreed premium price. Under options selling, you either sell a call option or a put option.
In option selling, the option seller is also called the option writer, who sells the option contracts to the option buyer. By selling the option contract, the option writer receives a premium from the buyer.
Option Buying or Selling Which is Better
Option selling, compared to option buying, is riskier because there is an unlimited loss if the market moves against your assumed scenario. You earn a premium, which is your income, which is also the limited profit you earn while selling the option contract.
On the other hand, when you buy an option contract, you pay a premium as upfront money and your maximum loss would be equal to the premium paid. However, for option seller there is a chance for unlimited risk if the market moves against your scenario. Hence, the question is which one is better.
When to Buy the Option Contract?
When the price action shown potential movement in either side, depending on the direction, buying an option contract would be profitable. If you think the market is bullish, buy a call option would be profitable, vice versa if the trend is bearish.
When the market or underlying security moves as per your expected direction but must have significant movement before the date of option expiry, then only you can earn the profits from buying the option contract.
If the market moves against your expectations before the date or expiry or remains on the same levels till the date of expiry in both conditions you will incur a loss. As the time value of money decreases the value of the premium you paid will become zero.
When to Sell the Option Contract?
Selling the option contract could be a profitable option trading strategy when you expect the market will not move beyond these levels. It could be the upper side or lower side if you expect the market will not have significant movement till the expiry date, and then you can either sell option call or put.
Selling the option call can give you a return when you expect the market will not go up beyond a certain level or might come down before the expiry day. And if you think the market will not go down beyond a certain level or trade around the same level till the date of expiry, then you can sell the put option.
Factors that Affect the Option Premium
To understand which one is better, option buying and option selling you have to understand how option premium works and how its value decreases with the time decay. There are four factors that affect the option premium price – Intrinsic Value, Time Value, Time Decay and Volatility.
Intrinsic Value
An option premium contains the intrinsic and time values. And the intrinsic value is the difference between the current market price and strike price of the underlying security. The spot price of the security nearer to the strike price has a higher potential to give profits to the buyer.
However, when the option is highly profitable, it is in the deep in the money (ITM), which means it has higher intrinsic value. On the other hand, an option with an out-of-the-money (OTM) has a lower intrinsic value. In the deep ITM, the premium you paywould be greater, and options that are out of the money have smaller amount of premium.
Hence, if you sell an option contract with the strike price too far away from the spots price, you have a better chance to make money at the end of the expiry. But the premium you will receive while selling the out-of-money contracts will be also smaller in amount.
Time Value
Time value is another factor that affects the value of the premium in the option contract. Time value is also known as the extrinsic value in option contracts which refers to the additional amount you pay above the intrinsic value of an option contract. Hence, an option too far away from the date of expiry has high premiums compared to the option contract near to expiry.
An option contract has both intrinsic and extrinsic value, and as it is far away from the date of expiry, the time factor also highly affects the price of the option. As soon as the expiry date arrives the impact on time also starts reducing which has a greater impact on the intrinsic value.
Hence, when you buy an option contract, and there is a long time till the expiration date, then there are higher chances to get a profit if the market or underlying security moves as per your expectations. The longer time duration provides a better scope of movement to market or underlying security.
On the other hand, selling the option contract near the expiration date has a better chance of giving a profit. As the option contract is near the expiry date there is a higher chance that it will expire while trading out of the money that will make it value zero.
Here you should keep one thing in mind, time value is the main factor that works against the option buyer. Hence, if you sell an option contract with a long time of expiry have a better chance of giving a profit to the option seller.
Time Decay
An option contract approaching its expiry date loses its time value, as there is less time remaining for the option buyer to earn the profit. Hence, you should never pay a high premium for any option that is about to expire or near its expiry date, as there is very little chance the option will become in the money or have intrinsic value.
Time decay is the process of decline in the value of option premium due to closeness of expiry date. Time decay is the value of option premium decline due to the passage of time and this time decay happens at a much faster speed when the expiry date arrives.
Option contracts with high premiums are beneficial for the sellers, once option sellers receive a premium, they wish the option contract to expire worthless so that they can digest the premium amount. An option seller never wants the contract he is sold to be exercised, they want to make the premium they receive as an income without fulfilling their obligations of buying the security.
Volatility
In the option market, volatility is another factor that affects the price of the option premium. Just like the individual stock or underlying security, there are various factors that affect the entire stock market. The economic news, political instability, economic growth data, fiscal policy, monetary policy, company-specific fundamental factors and technical factors all also affect the volatility index (VIX) of the stock market, and the underlying securities in the options market.
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When volatility is high the price of underlying security also faces major fluctuation in price, and when the volatility is low, the price of underlying security also has low or moderate fluctuations. In the option market, for option buyers, the high volatility underlying security is good as there is a high chance of the option expiring in the money.
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On the other hand, for option sellers, low volatility underlying security is good as the option is likely to expire out of the money. But keep one thing in mind during high volatility, the option premium also becomes high and in low volatility, the option premium also becomes low.
In the high volatile market conditions, the buyers have to pay a higher premium, while during the low volatile market conditions, the seller gets the lower amount of premium.
Why Selling Options is better than Buying?
One of the biggest advantages of selling the option is time decay or the speed at which the option contract becomes worthless. And when the option settles at zero, the premium price of the option becomes the income for the option sellers.
Here if you want to sell an option, you have to measure the rate of decline in the time value of an option affected due to time decay or you can say passage of time. This kind of measure is known as theta which is usually expressed in a negative number and is basically the amount by that rate the value of the option decreases every day before the expiry date.
Hence, selling an option is a positive theta trade, which means the option seller will make more money as the time decay increases. For option buyers theta is negative, therefore option buyers can lose money even if the underlying security does not move or moves at a very slower speed in the expected direction but does not manage to offset the time decay.
Therefore an option buyer always expects the underlying security should move in a single direction to book the profit. As the option buyer pays for both intrinsic and extrinsic value (time value), hence he needs to cover at least his extrinsic value to book profit.
The time decay is more favourable for the option sellers, as it not only decays on each working day but also on the weekends and holidays giving the better chances to option sellers make money.
Nevertheless, option sellers already receive the money, in the form premium at the time of entering into the contract. Hence, with the decline in intrinsic value and time decay, option sellers will be more benefited. And option sellers can also close their option any time before the expiry day, if the option premium has declined and book some profits.
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Risk Factors in Selling Option
One of the major risks in option selling is if the market or the underlying security moves in the reverse direction or against your expectations with a significant movement before the date of expiry. Though it is not possible or possible in rare market conditions here, the risk could be unlimited if the market or underlying security keeps moving in the opposite direction. You can incur huge losses if the option buyer is asking to exercise the option contract before the expiry.
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Another risk or you can say the limitation of option selling is there is limited profit that you have already received in the form of a premium. Hence, while selling the option choose the right strike prices that have the potential to make your trade profitable and also have a significant amount of premium so that you can receive a substantial amount of profit.
Hence, if the expiry dates are too far away, you should avoid selling the option until you are sure that the market will not move in a single direction. Option selling near expiry works well due to time decay having better chances of making your position profitable.
Expiry Day Option Selling Strategy
Option selling on expiry day, means you are going to sell options on the date of expiry that can be capitalized due to the rapid time decay of value of the premium. On expiry day the theta decay is faster, and all out-of-the-money options become almost zero having better chances of giving the profits to the sellers compared to the option buyers.
In the expiry day option selling strategy you can choose the OTM option or with a strike price far away from the spot price of the underlying assets, as there is less chance of getting exercised. There are various popular option strategies like short straddle, short strangle or iron condor strategy that you can use to enter into a trade position on the expiry day.
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Things to Consider While Selling Options
Option selling could be more profitable when the market is not highly volatile or there is no significant movement in any direction. But there are a few things you need to consider while selling the options to minimize your risk and increase the chances of profitability.
- Trading in the option market is risky, hence while selling the option always trade with stop-lossto protect your trade position from unlimited loss. However, trading in the stock market either its intraday or short-term trading or options trading always uses the stop-loss.
- While selling the options, you need to pay a higher amount compared to option buying. An option seller is liable to pay the margins called MTM along with additional volatility margins on a daily basis as per the market conditions that are adjusted on the expiry day.
- Selling the in-the-money option comes with a higher risk but has a higher premium. While out-of-the-money options have low risk with lower premiums, hence take the right decision of choosing the right option strike as per your risk and affordability.
- The value of time decay is the most important factor while selling the option, as the value of the premium keeps exhausted with time. Hence selling the too-far way options could be risky but gives you enough time to exit from your trade position or book profit.
- As per the global data in financial markets, most of the option contracts expire worthless on the date of expiry. Hence, there are higher chances of earning profits from option selling compared to buying an option contract.
