TradeWins Inside Trading Newsletter

March 10, 2020

Trust This Pattern

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Option Buyer/Option Seller – Who Has the Edge?
by Dave Caplan

This is a question that has haunted every serious trader of options. Do I sell options and take advantage of the time value decay and mathematical probability? Or do I purchase options to take advantage of the limited risk aspect and the potential for unlimited profits?

Ever since I began trading options, I have heard arguments regarding the benefits and disadvantages of option buying and option selling. Option buyers commonly cite the benefits of limited risk and the potential for unlimited profit; while option sellers point to the advantages obtained through using premium disparity and time decay of option premium.

Some of this material can be classified as "self-interest" depending on who has prepared it. The brokerage houses promotional material usually discusses option buying, centering on the benefits of the limited risk aspect of options and the potential for unlimited profits. The potential for unlimited profits is, of course, of great interest to the individual speculator, while the security blanket of limited risk provides protection for BOTH the trader and broker. (While a futures trader or a trader that is short an uncovered option has the potential for unlimited losses, an option buyer can only lose the amount of the premium paid). Further, a brokerage company has an easier time developing promotional material explaining the benefits of purchasing options, which is far less complicated to explain and monitor than option sales.

On the other side of the picture, much of the material regarding option selling is written by research analysts and floor traders. Research analysts, particularly those who have not had extensive experience trading, probably have the easiest time explaining the benefits of short option positions. Further, the researcher can mathematically show how with proper money management that it is impossible to lose money on short options.

Experienced traders know, however, that nothing is impossible in the markets. Unless a trader has had actual experience of what can happen with option pricing during a drop of 500 points in the Dow due to the commencement of international political turbulence or war, these explanations will be meaningless when the trader is caught in the vise of rising volatility and huge price swings.

Floor traders, as a group, are the largest sellers of options. They typically sell options and then hedge their positions with futures contracts. This process is an excellent venture on the floor, but unworkable by all floor traders. This is best because the transaction cost, slippage, and time delay of entering orders will cause any advantage to be lost by those trading off-floor.

As usual in these types of arguments, the truth lies somewhere in between. Both long and short options have their benefits and detriments, depending on the conditions of the futures market and options volatility levels.

When futures options were first introduced in 1982, there were often valuation problems because of the trader's inexperience with options. Out-of-the-money options, especially call options were typically overvalued, compared to the closer-to-the-money options, sometimes exceeding twice the volatility level. For example, during silver's brief rally in 1986, the out-of-the-money calls were trading at a volatility level more than double the at-the-money options. This disparity, of course, led to all types of opportunities for option sellers including ratio spreads, neutral positions, etc.

Also, any time a new option market opened, there seemed to be extreme disparities in option premiums especially in the out-of-the-money options (probably because of inexperience in valuing these options). Secondly, during this period, bull markets would cause premiums to skyrocket. I attributed this to the demand for "cheap" options by small traders.

A trader bullish on a market can either buy a call or sell a put. Both are bullish strategies, but with entirely different characteristics, risk/reward, and probability of profit. Both sides look good on the surface, and contain the qualities that are touted by the brokers and exchanges as the reasons for using options.

However, before any decision is made by the trader as to whether option buying or selling strategies may be better, he must also assess current market conditions in both the futures and options markets, and the disadvantages that may be evident with either under the current conditions. Unfortunately these aspects are quite often overlooked by many traders, who see only the benefits of option strategies. Before any answers are possible, we must look at the fundamentals underlying option buying and selling.

The "perfect" environment for sellers of option premium is a market that has high option volatility (when option volatility is high, the "time value" premium of an option increases greatly), is just entering into a consolidation phase, or at worst, a slow trend. These are excellent markets in which to initiate the "neutral option position" (selling an out-of-the-money put and call), as this strategy will take advantage of both the time value decay of the "overvalued" out-of-the-money options, as well as the loss of premium by the lessening option volatility which often occurs in this instance.

We have seen this opportunity in the currency options market in the beginning of 1988; in the S&P after the October crash in 1987; in crude oil in 1990/1991 during the Gulf War; and just about every summer for the last five years in grain markets. In all of these situations the historically high option volatility levels caused option premium to decline quickly once these markets become less emotional and entered normal trending phases.

Another of our favorite times to initiate the "neutral option position" is when markets are consolidating or slowly trending over the long term, or have seasonally shown the tendency to maintain a trading range.

These trades work great in flat, choppy and consolidating markets for traders like myself that hate to predict market direction. (Another real benefit of the "neutral option position" is that you only have to predict where the market ISN'T going; not where you think it is going to go).

Option buying on the other hand, is attractive to traders seeking a position that has potentially unlimited profits, and risk that is limited only to the premium paid for the option, no matter how far the market moves against you. The risk/reward on this position can be exceptional, usually at least 10 to 1 in the trades we recommend, and at times it can be substantially higher. However, this being the real world where there are exceptional benefits, there is generally some "catch." The "catch" here is that the mathematical probability is often against the option buyer.

The reason is when purchasing an option, precise timing is needed to properly enter and exit the trade, or else potential profits can be eroded by the "time decay" that effects all options every day. A trader becoming bullish, in August, 1992, could have purchased a December bond 104 call, and three months later with bonds trading about two points higher ($2,000 per contract profit in a futures contract), would have seen the price of this option decline about 25%.

Although the allure of unlimited profits seems promising, the reality is that without a proper plan, the option buyer is facing heavy odds. Further, the purchase of an option with extremely high volatility (premium), an option that is too far out-of-the-money or too close to expiration, further dooms the potential purchaser of options to a trade that is likely to lose.

However, as long as we have significant quick moves in the markets such as he grains in the summer months during crop problems; in the S&P during the "October Effect"; in crude oil, the metals and currencies in times of a national crisis; there will be option buyers around seeking to take advantage of these opportunities that can be extremely favorable at certain times.

As you can see from our analysis, there are benefits to both option buying and selling that are useful at various times. The professional trader learns the benefits and disadvantages of these strategies and the best time to use them. He will not hesitate to stay on the sidelines if no trade is available that provides a "trading edge" over the markets. At the same time he has to be ready to use option selling techniques to his advantage in choppy trading range markets and markets that have high option premium; while being ready to use option purchases in markets that have well priced options to put themselves in a position to profit, should a potential quick move occur.

Trade like a professional. By being knowledgeable, keeping alert and remaining flexible, you can keep the odds in option trading in your favor by knowing the right time to buy or sell options. The professional trader will not favor one strategy over another, but allow the fundamental and technical pattern of the underlying market as well as the option volatility level dictate to him which strategy is best to use for the current markets.

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Trust This Pattern

Option Buyer/Option Seller – Who Has the Edge? by Dave Caplan

Option Buyer/Option Seller – Who Has the Edge?
by Dave Caplan