The stock market is typically categorized into three types of movements: bullish, bearish, and sideways. An option seller has a strategy that can be profitable under a variety of these market conditions, making it a more attractive choice for traders.
Understanding Bullish and Bearish Movements
When an option seller bets on a bullish market, their chances of success are high. They win if the market moves in a positive direction or even if it moves sideways. The only scenario in which they incur a loss is if the market experiences a significant bearish move. This simplifies the probability of success for the option seller to at least 66%, providing a robust foundation for their strategy.
Option Buying vs. Option Selling
Buying options is a different strategy altogether. If you purchase options, you are essentially betting on a specific stock’s performance in the future. However, most of the time, the underlying stock or contract fails to breach or cross the strike price at which the options are held. Due to this, the majority of options expire worthless, and you don't win as often as you expect.
Statistical Analysis
Statistically, a significant proportion of option sellers succeed. For example, in any given option contract, 90-95% of out-of-the-money (OTM) strikes expire at zero, meaning 90 out of every 100 option sellers make a profit.
Risk Management in Option Selling
However, while option selling appears to be a straightforward task, it is not without its challenges. Traders must be aware that option selling trades are often skewed in terms of risk versus reward. An option seller needs more capital to manage their trades effectively and must have a high level of skill to handle unfavorable scenarios. Even a single incorrect trade can lead to significant capital loss, making this strategy risky despite its high win rate.
Profitability and Risk-Return Trade-off
Options strategies, such as strangles or iron condors, often have an asymmetric profit to loss ratio, which means that while an option seller may have a high win rate, their overall profitability may not reflect this success. For instance, in a sequence of trades like this: 2525252525 - 2002525, the seller would see seven profitable trades and one loss, leading to a win rate of approximately 90%, but a negative net profit.
Conclusion
Option writing is a more profitable strategy than option buying due to its higher success rate and risk management advantages. However, option sellers must be meticulously managed, requiring a solid understanding of market dynamics and strong trade management skills. Although the strategy can be challenging, the overall profitability can make it a worthwhile endeavor for savvy traders.
Note: For a detailed analysis of this topic, please refer to Vikas Gupta's comprehensive answer on the same question.