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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 unlimited.

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 totally identical trading systems 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 say that:

1. 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).
2. 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.
3. 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 options seller.
4. 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.
5. 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 options.

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