You can make money, either buying or selling options. But what most new options traders don’t fully appreciate is that selling options (also referred to as writing options) has more advantages than buying them. Most new option traders are enamored with the idea of buying options. Where they can spend as little as a few hundred dollars of premium and 10x that trade into a few thousand dollars. Completely understandable and reasonable, but there is one problem. The vast majority of option buyers lose money. For new option traders, the thought of making only a few hundred dollars on a trade selling options is a lot less appealing. The thing is the probability, and the volatility risk premium is far more in your favor when selling options.
Time Is on Your Side
One of the main advantages of selling options is that time decay works in your favor. Time decay (or theta) refers to the fact that the value of an option decreases over time.
First, recall that options are contracts that give the buyer the right but not the obligation to buy or sell shares of an underlying equity at a fixed price (called the strike price or exercise price) by a specific date (called the expiration date or exercise date). For the privilege of having this option, the buyer pays the seller a fee, called the premium. (Need a refresher on options trading? Check out our introductory article here, where we go over the basics and provide tips for getting started.)
The value of the option is the highest when the option is purchased. As time goes on, the option’s value progressively erodes. If the option has not been exercised by its expiration date, it has no value whatsoever.
All options are subject to time decay. Options lose value every day. But time decay does not occur at the same speed for all options. The amount of value that options lose each day is connected to their expiration date. For example, Option 1, which has an expiration date in three months, has slower time decay than Option 2, which has an expiration date in one week. Why is this the case?
The expiration date for Option 1 is far off. No one can accurately predict how the stock market (or the underlying equity that is being optioned) will perform between now and then—it could soar, nosedive, or steadily motor along without significant ups or downs. Because the expiration date is months in the future, the buyer of Option 1 has lots of time to exercise their option if the underlying equity moves in a direction that is advantageous to them. The same cannot be said for the buyer of Option 2. Because the expiration date is rapidly approaching, there is less time for the underlying equity to move in a direction that makes exercising the option attractive.
Time decay is bad news for the option buyer, but great news for the option seller. To understand why this is the case, it is vital to understand the option seller’s strategy. Recall that there are two classes of options: calls and puts. Buyers of call options hope that the share price of the underlying equity will rise to or above the strike price while sellers of call options hope for the opposite: they want the share price to remain below the strike price. Meanwhile, buyers of put options bet that the share price of the underlying equity will fall to or below the strike price. In contrast, sellers bet that it will remain above the strike price. What does all of this have to do with time decay?
As time marches forward, it becomes increasingly unlikely that the buyer will exercise the option. This is a good thing for sellers who do not want buyers to exercise their option. Sellers want the option to expire out-of-the-money (OTM), which means that the strike price stays lower than the share price (in the case of calls) or higher than the share price (in the case of puts). If the option is OTM, then the buyer will not exercise the option and the seller can pocket the premium.
Time decay is also useful for sellers who, for whatever reason, do not want to hold the option contract until it expires or until the buyer exercises it and wants to close their position. Recall that time chips away at the value of an option, lowering its price. (There are other factors besides time decay that affect the value of an option, but let’s keep it simple and solely focus on time decay here.) This means that a seller can buy back the option at a lower price than what they sold it for. Say, for example, that a seller sold a call option on August 1 with an expiration date of October 15 for a premium of $10. On September 12, they decide they no longer want to hold the option. Because significant time decay has occurred, the option only costs $6 to buy back—the seller exits with a $4 profit.
Admittedly, $4 is not as much as the $10 the seller would have kept if the option had expired without being exercised. The upside, though, is that the seller is out of the deal: they earned a profit. They avoided having to part with shares of an equity they owned (for a covered call) or having to purchase shares of an equity they did not own on the open market and then selling those shares to the buyer at the strike price (for an uncovered call).
You Can Profit If the Market Goes Up, Down, or Sideways
If you buy a call, you want the share price of the underlying equity to increase to the strike price or above it. If you buy a put, you want the share price of the underlying equity to decrease to the strike price or below it. Options buyers can only profit if the market goes in the direction that they want it to. Let’s imagine you buy an option that is a 33 delta. Delta can be loosely interpreted as the percentage chance that option will finish in the money. Therefore, all other things being equal, there is only a 33.3% chance that underlying equity will move in the direction that the buyer wants. Put another way, there is a 66.7% chance that the market will not move favorably, and the buyer will have to exit the deal out the cost of the premium.
Options sellers, on the other hand, can in many instances, collect profit from a market that goes up, down, or stays roughly the same (the latter is called a sideways market). Say that you sell a put with a strike price of $50 for a premium of $7. The share price for the XYZ Corp., the fictional name of the underlying equity that you sold an option for, is $60. The share price of XYZ Corp. can skyrocket to far above $60, hover around $60, or dip down to $51. Because the share price has not dipped to $50 or less, the option will not be exercised, and you can keep the premium, $7, as profit.
Implied Volatility Is Your Friend
Recall that implied volatility (IV) is a measure of traders’ educated guesses about how a particular equity (or the market as a whole) will perform in the future. Volatility and its relationship to options trading is a complex subject—to learn more about it, see our primer on the subject.
For our purposes, what is essential to understand is that the higher the implied volatility of an underlying equity, the more expensive the option premium. The opposite is also true: the lower the implied volatility, the less expensive the option premium.
How does all of this work in the options seller’s favor? To reap the most profit, options sellers can sell options for underlying equities that have high implied volatility, as the premiums for these in-demand options are pricier.
According to the theory of mean reversion, highly volatile options will likely become less volatile and, therefore, cheaper over time. If an options seller wants to exit the contract, they may be able to buy back the option at a lower price than the price at which they sold it. Of course, this amount will be less than the full premium, but it is still a profit.
A Few Words of Caution
It is important to remember that selling options, despite their numerous advantages over buying options, is not free of risk. All options trading—all trading, has risk.
Sellers make their money by collecting premiums. Their strategy is to sell options that they bet will not be exercised or that they can buy back at a discount before they are exercised. Sellers must remember, however, that buyers’ strategy is the exact opposite. Buyers want to exercise their options and, if they do, sellers must fulfill the contract.
Fulfilling the contract means that sellers must sell shares of the underlying equity to the buyer at the strike price (in the case of calls), or they must buy shares of the underlying equity from the buyer at the strike price (in the case of puts). If the options contracts are uncovered—that is, if the buyer did not already own shares of the underlying equity—then they may face significant losses.