What Is An Option?
An option is a contract between two parties: the writer and the holder. In the stock market, the writer is often referred to as the seller, and the holder is referred to as the buyer.
In our Options Trading Guide we pointed out that the holder of the option the right, but not the obligation, to buy or sell an asset at a specified price on or before a specified date. In exchange for leasing this right to the holder, the writer of the option gets what is called a premium. A premium is simply a sum paid to the writer, basically acting as their fee.
- Option Buyer = Holder
- The right to buy or sell the underlying asset at a specific price
- Options Seller = Writer
- The obligation to buy or sell the underlying asset if the contracts are assigned
- Option Buyer = Holder
Selling Options Example
Let’s look at a real-life example. Tom is a commercial real estate developer in NYC and found a lot that he wants to build an apartment complex on in the next 18 months, but before he can put a down payment on this property, he needs the cash from his last project to come through.
With the NYC real estate market being so expensive and volatile, he’d like to lock in today’s price, as who knows how much it will be 18 months from now? So he goes to the land owner, Bob, and strikes an option contract with him.
They come to an agreement that gives Tom the right to buy Bob’s property at the current market value of $1 million for the next 18 months, in exchange for this right, Tom pays Bob $50,000.
Here’s how the logistics of this transaction work out:
- At any time in the next 18 months, Tom can buy Bob’s property for $1 million.
- Tom has no obligation to buy the property at anytime. Tom can let the contract expire if he’d like.
- For the next 18 months, Bob cannot sell the property to anyone else except Tom, or whoever Tom sells his option contract to.
- Regardless of what happens, Bob keeps the $50,000. That is his fee for tying up the property for 18 months.
Buying Vs. Selling Options
In the above example, Bob is the seller of the option. In the stock market, there are Bobs and there are Toms. Generally, Toms are speculators, hoping for a huge price move in the option they bought.
Bobs write options because they know that most options expire worthless, allowing them to keep most or all of the premium the vast majority of the time. Bob makes consistent, predictable income, while Tom’s portfolio is full of losses with the odd big trade to keep him coming back.
The Problem With Buying Options
Let’s do a hypothetical example for illustrative purposes. You’re bullish on Apple stock and think the stock price will be above $230 by mid-October, so you buy a $230 call option expiring on October 18th, costing you $1.37 in premium. ($1.37 per share x 100 = $137 option).
If the price of Apple is $235 at the expiration date of your option, your profit would only be $3.63, because you paid a $1.37 premium for the position. So immediately when buying options, you’re fighting an uphill battle because your profit has to exceed the premium you paid to initiate the position.
As the buyer of an option you have to get price direction right, really right, enough to exceed your premium, and you have to get the timing right. It means nothing if Apple goes to $235 a week after your expiration.
Seeing as the stock market is already a negative-sum game (after factoring in commissions, fees, and paying spreads to HFTs), it seems foolish to add more factors to play against you.
Selling Options: The Casino
So we’ve established that in the big picture, buying options is a losing proposition because you have to pay a premium to establish a position within a zero-sum game (financial markets). So naturally, taking the opposite side of that bet is a winning proposition.
Selling options is a lot like a casino. The house has a small, but well-defined edge in their games. They know that over the long-term, they will realize their expectation, and in the interim, they will take some losses, sometimes large ones, to realize that. Sometimes a high roller will take them for a few million, but they know what their bottom line looks like.
Perhaps a more fitting analogy is that selling options is like running your own stock market insurance company. You’re underwriting risk for a premium, just like insurance companies do. Insurance companies do this because they’ve looked at the data and identified that, in the big picture, there’s a positive expectation in to what they do, so paying a few large claims is just part of the game for them.
Time Decay: Like Supermarket Produce
Imagine options as produce on a supermarket shelf. It has a limited life, and it’s value diminishes as it gets closer to the end of its life. Supermarkets routinely markdown their browning bananas and produce approaching it’s expiration date. The same applies for options. Everyday closer to an option’s expiration reduces its value.
Think about the example in the first section. Isn’t it more valuable for Tom to have an option to buy the NYC lot for 18 months than 2 months? That’s time decay.
As an options seller, you’re putting time decay in your favor, it’s like short selling bananas!
Smooth Return Stream – Selling premium is one of the most predictable sources of returns in the market. Premium selling strategies generally have a high win rate and are a good way to quickly grow trading account. Of course this comes with the caveat that your losses will outsize your winning trades.
Implied Volatility Is Generally Overstated – We all know that the VIX is the “fear index” of the stock market. If you’ve done any studying of the VIX, you’ll know that it generally forecasts a much darker view of the future then what ends up occurring.
Well, the VIX is basically measuring the implied volatility of SPX options, it casts that dark picture of the future because implied volatility as a whole is generally overstated. Option sellers can take advantage of this phenomenon by selling options with high implied volatility levels.
Good For Trading Psychology – Most traders would benefit from a system that has them winning a high percentage of trades. It gives them a sense of confidence, leading to less second guessing and needless tweaking of models.
No Home Run Trades – This is the other side of the “good for trading psychology” argument. The knowledge that a big home run trade could be right around the corner is what keeps some traders coming back to the screens everyday, scalping about, waiting for that big opportunity. That opportunity won’t come as a seller of options.
The difference between the return distributions buying and selling options is quite similar to that of mean reversion and trend following trading systems.
The returns of mean reversion systems are generally focused near the mean, generating many small wins, with a fat tail on the left, representing the sometimes catastrophic losses that can occur in such a system. Trend following, like buying options, has a much lower hit rate, with small losses and big wins.
Potentially Catastrophic Losses – There’s no such thing as a free lunch. Any strategy with a smooth equity curve like premium selling will have it’s large drawbacks, and the potential for catastrophic losses is premium selling’s main drawback. Take the infamous case of OptionSellers.com, a CTA firm which lost all of it’s client’s money, leaving many in debt to clearing firms.
Won’t Make You Rich – While buying options is an uphill battle, the benefit carried is buying the right option can multiply your account overnight. There’s plenty of cases of traders buying an OTM call and getting lucky. Of course, we don’t trade on luck, but there’s no chance of waking up to find your calls you bought for pennies trading for $20 when selling options. You know your max reward going in, which is the total premium collected.
Selling premium is often referred to as “picking up pennies in front of a steamroller,” and that can often be true, especially in unfamiliar or changing market environments. But, as we’ve stated, there’s no such thing as a free lunch. Of course a strategy with such a significant structural advantage will have some major drawbacks in other areas.
To summarize, premium selling is known to generate a smooth equity curve, with the occasional large loss. It’s return distribution is similar to several mean reversion stock trading systems.
To provide some proof of concept, Marty Schwartz, one of the best known traders of all time, has recently begun heavily implementing premium selling strategies within his own trading.