Selling Options Short versus Buying Options.
Selling options (uncovered options trading, selling
naked options) short is considered one of the more risky trading
strategies for investments. However this is one of the options trading
strategies that is usually used by institutional investors. As a rule
uncovered options trading
requires a trader to meet certain margin requirements and with a
majority of brokers this is available only with the highest brokerage
account level. No wonder that in the majority of situations the
uncovered options trading is simply not accessible to the retail
traders. The high margin level is set because the naked options trading
is considered the high risk investment where a trader has potential
profit limited to 100% and yet the potential loss is theoretically
So, the question is why do uncovered options attract
the institutional investors? Unlimited loss and limited profit do not
look very attractive in comparison to buying
options trading strategies
where a trader has unlimited potential profit and potential loss is
limited to the premium paid for the options.
By looking a little deeper into the nature of the
naked options you may find a simple answer. Just try to compare two
with the one difference being that system #1 buys options while system
#2 sells options. In other words you may take two traders that use the
same trading system:
- When the
system issues a long signal, the first trader buys calls and the
second trader sells puts
- When the
system issues the short signal, first trader buys puts and the
second trader sells calls.
By monitoring these two traders, you may notice that
the probability of making profitable trades is higher for the second
trader (uncovered options trader), plus, the second traders closes
positions with better results more often and fixes smaller losses. Of
course, if the system is a total failure and generates loss after loss
and does not use stop-loss where a second trader may report 500% losses
upon expiration versus 100% losses of the first trader, then the
uncovered options trading is extremely risky. But in this case we would
say that this trading system is not worthy of being used with any type
of trading at all.
The above example of two traders could be explained by
the nature of the options. The price of the options is affected by time
- options loose value with time. The longer you stay in the position the
cheaper options become. The closer options are to expiring, the cheaper
options become. The closer to the options expiration the faster the
options price drops.
You may very often see situation when the underlying
stock rises by 1% and the options on this stock rise by 20 %. Then after
some time the same stock declines by the same 1% and the options on this
stock may drop by 22%. Basically, the stock is on the same level however
the options on this stock become cheaper with time.
The time factor is an options seller's ally and plays
against an options buyer. Even if the underlying security moves somewhat
against the direction of the short position, the sale of short options
can still bring in a profit due to an option's time value erosion. On
the other hand as a general rule, the longer the first trader (an option
buyer) stays in a position, the greater the risk that the purchased
option will drop in value - even if the underlying security moves
slightly in favor of the position.
By summarizing the affect of the time factor we may
If the market moves in favor, then both the options
seller and options buyer will receive a profit. As a general rule
the option seller will report a higher profit especially if the
position was opened long enough. The only exception to an options
buyer reporting a bigger profit is when the profit exceeds 100%
(very rare situation).
If the market moves slightly to a favorable position,
an options buyer may suffer a loss if it was prolonged in time and
an option seller will still profit.
If the market moves flat (it moves flat most of the
time), the option buyer looses and options seller reports profits.
The longer the position is opened the bigger the loss will be on the
options buyer's account and the bigger profit will be received by an
If the market moves slightly against a position an
options buyer will suffer a loss and an option seller may suffer a
smaller loss or may even report a small profit depending on how long
the position was opened.
If the market moves against the position
substantially, both options seller and options buyer will suffer
losses. As a rule the options buyer will suffer bigger losses unless
the losses overcome the 100% level when the options seller is not
limited to a 100% loss.
By the affect of time factor (time erosion) on the
options price, it becomes clear that option sellers have more
opportunities to profit. Option sellers only lose money if the
underlying security moves substantially against their position (i.e.,
contrary to the predicted direction). An option buyer on the other hand
has the advantage when it comes to limiting potential losses. In this
case everything becomes dependent on personal trading style: how long a
trader stays in the position, what stop-loss level is used...
In summary: Option sellers have more
opportunities to profit, but they face a greater risk of larger
potential losses. In some situations, losses may be mitigated by the use
of a stop-loss strategy. The options selling could become very risky
with individual stocks. Index options are safer than individual equity
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