From active speculation to risk management, traders take advantage of the unique flexibility of options on a routine basis. However, in contrast to standardized futures products, trading options requires a bit more expertise. Let’s examine the mechanics of buying and selling options contracts.
Options 101: Buying Calls and Puts
No matter what product you’re trading, buying and selling are typically the two basic actions. In most markets, when a buy order is executed, a new long position is opened. For a sell, either an existing long is closed or a new short position is created at market. These actions are an essential part of the futures, currency, and equity trades.
By comparison to more traditional securities, the functionality of options is unique. While it’s true that buying and selling options contracts are key elements of active trading, each may be accomplished in numerous ways using calls and puts. Here is a quick breakdown of each:
- Calls: The buyer of a call option has the right to purchase the contract’s underlying assets at a specified price (i.e. strike price) on or before a forthcoming date in time.
- Puts: The buyer of a put option has the right to sell the contract’s underlying assets at a specific price on or before a forthcoming date in time.
When you buy a call or put option, the premium is the price paid for the opportunity to execute the contract according to its specifications. The premium is the liability assumed by the trader: If a beneficial move in price deems a contract to be “in the money,” a financial gain may be secured only after the premium is exceeded.
Strategies for buying calls and puts may be crafted to favor either the bullish or bearish side of the market. For example, when you buy a call option, you open a long position and profits are realized from price appreciation. If you buy a put, you assume a bearish stance, with gains banked from falling asset prices.
Options 101: Selling Calls and Puts
In contrast to buying calls and puts, selling options is counterintuitive. Instead of paying the contract’s premium for the right to buy or sell at some future point in time, you collect the premium upfront and are “assigned” the obligation to sell a product, if exercised. This is a key distinction because liabilities of uncovered positions are potentially unlimited.
When you sell or “write” an options contract, any number of strategies may be put into play using calls and puts. Here are a few:
- Calls: Selling calls is one way investors insulate long-term positions from short-term drawdowns in value. By selling a call, falling asset prices ensure that the premium is realized as profit. These types of strategies favor a bearish market bias and are commonly executed in the equities markets.
- Puts: When a trader sells a put, a bullish position is essentially opened in the market. The contract represents an obligation to buy at the distinct strike price at some point before expiration. Thus, if asset values hold firm above strike, the contract expires worthless, and the premium becomes realized profit.
Is It Better to Buy or Sell Options?
It’s no secret that market participants selling options typically outperform buyers at a near 60/40 clip. The odds favor the party that writes the contract, due to the concept of time decay.
Options contracts are perishable securities in that they have an expiration date. As time passes, the chances for “out of the money” positions to expire worthless grows. In addition, periods of low volatility can hamper the odds of significant pricing variations above and below strike. This is an important element of options and another that favors the seller.
So, if the chances of success are skewed in favor of the contract writer, why doesn’t everyone sell options? Simply put, the answer is risk. Upon writing an option, the seller is assuming a potentially unlimited risk. If not properly covered by separate market positions, periods of high volatility or untimely Black Swan events can cause catastrophic losses. This was the driving force behind the $150 million meltdown of optionsellers.com during the Fall 2018 natural gas rally.
Is Selling Options Right for Me?
Before adopting any financial plan, it’s essential to speak to an industry professional. To learn if selling options is right for you, schedule your complimentary one-on-one conversation with a member of the Daniels Trading team today.