Understanding the Dynamics of Selling vs. Buying Options: When Does Selling Result in Higher Profits?
Introduction to Options Trading
Options trading involves contracts giving the holder (buyer) the right, but not the obligation, to buy or sell an asset at a predetermined price before a specified date. To understand the nuances of selling options versus buying them, it's crucial to grasp the mechanics and risks involved in both strategies.The Basics of Buying Options
When you buy a call or put option, you are essentially placing a bet on the future price of the underlying asset.Buying a Call Option: - You buy a call option to have the right to buy the underlying asset at a predetermined strike price by a specified expiration date. - If the strike price is 35 and the stock price at expiration is 37.60, your profit would be (37.60 - 35) * 100 shares 260. - Remember to deduct the premium you paid for the contract.
Buying a Put Option: - You buy a put option to have the right to sell the underlying asset at a predetermined strike price by a specified expiration date. - If the strike price is 40 and the stock price at expiration is 36.20, your profit would be (40 - 36.20) * 100 shares 380. - Deduct the premium you paid for the contract from your profit.
The Mechanics of Selling Options
Selling options involves the seller (writer) owing the underlying asset at the strike price if the buyer decides to exercise the option.Selling a Call Option: - You sell a call option to have the obligation to sell the underlying asset at the strike price if the buyer chooses to exercise the option. - If the strike price is 38 and the premium received is 0.45, and the stock price at expiration is 37, you win the bet as the option expires worthless, and you keep the premium (0.45 * 100 shares 45). - If the stock price at expiration exceeds the strike price, for example 39, the option will be exercised, and you will profit by the difference (38 - 39) but not as much as if the stock price rose, since the profit is capped by the premium received.
Selling a Put Option: - You sell a put option to have the obligation to buy the underlying asset at the strike price if the buyer decides to exercise the option. - If the strike price is 39 and the premium received is 0.52, and the stock price at expiration is 39.50, you win the bet as the option expires worthless, and you keep the premium (0.52 * 100 shares 52). - If the stock price at expiration is less than the strike price, for example 38, the option will be exercised, and you will profit by the difference (38 - 39.50), but your profit is capped by the premium received. - Your profit on selling options is limited to the premium received.
When Does Selling Options Result in More Money?
To determine when selling options results in higher profits than buying them, consider the following:* For Selling Options:
- Your profit is capped at the premium you receive. - If the underlying asset price moves unfavorably against you, the loss is limited.* For Buying Options:
- Your profit is potentially unlimited. - The risk of unlimited losses exists if the underlying asset price moves unfavorably in your make more selling options than buying, the premium needs to exceed the difference between the stock price and strike price for a bought call or between the strike price and the stock price for a bought put. Essentially, only when the premium is relatively high compared to the movement in the stock price can selling options be advantageous.