Buying Options vs. Selling Options (Risk/Reward, Probabilities & More)

in this video I'm going to break down the big differences between buying options and selling options as trading approaches specifically I'll outline the probability of making money the risk and reward potential how each approach makes and loses money and much more so be sure to stay tuned if you're brand new to the channel be sure to subscribe and enable notifications if you're interested in getting all of our options trading videos in the future when it comes to every single trade there is a buyer and there is a seller so when it comes to trading options what are the primary differences between buying options and selling options as trading approaches it's important to understand the key differences between buying options and selling options as trading approaches so you can first figure out which camp you align with more and so you can understand the difficulties associated with each approach let's start by analyzing the risk and reward potential when comparing buying options and selling options perhaps the biggest attraction of options trading is the concept of leverage which is being able to make a lot of money from just a little bit of money and the ability to control your risk and reward potential for every trade that you put on when it comes to buying options or option buying strategies the reward potential is typically far greater than the risk taken for that particular trade which is one reason a lot of traders prefer buying options over selling options let me show you what I mean by that by looking at some real option prices that I recently observed in the market on April 18th 2019 Netflix was trading for three hundred and fifty eight dollars and 19 cents now the particular expiration date that I looked at is May 17th 2019 which at the time had 29 days to expiration the strategy that I looked at was purchasing the 355 call option on Netflix that expired in 29 days and that 29 day 3:55 call option was trading for a price of $14 in five cents which actually translates to a valuation of one thousand four hundred and five dollars since every option is quoted on a per share basis and regular stock options correspond to 100 shares of stock if a trader was extremely bullish on Netflix meaning they anticipated Netflix share price would increase significantly in the near future buying the 29 day call option with a strike phrase of three hundred and fifty five dollars for fourteen dollars in five cents could be an attractive trade because one of the benefits of buying options is that the risk is completely limited to what you pay for that option so in the case of buying the 355 call option for 14.5 cents the worst case scenario is that the option expires worthless and the trader loses one thousand four hundred and five dollars for every call option that they purchased so in this example in terms of risk and reward the maximum loss potential or the risk is one thousand four hundred and five dollars while the maximum reward potential or the maximum profit potential is theoretically unlimited because since there's no limit to how much Netflix can increase - there's no limit to how much that 355 call option can be worth in the future which means in theory that trade has unlimited profit potential so if unexpected news came out and the Netflix stock price increased to four hundred dollars that 355 call option would be worth at least forty five dollars since a call option that has a strike price below the stock price will always be worth at least it's intrinsic value and four call options the intrinsic value is equal to the current share price minus the strike price and if Netflix is at four hundred dollars and the strike price of the call option is three hundred and fifty five dollars we know that three fifty five call option will be worth at least forty five dollars with a purchase price of 14.5 cents an increase in that options value to forty five dollars would represent a two hundred and twenty percent return on the investment that that trader made which is a very sizable return for a trade that lasted less than 29 days so what's the catch well when buying options you need something favorable to happen and fast for you to make money on that trade in the case of buying a call option that means you need the stock price to increase and/or you need implied volatility to increase before the option expires for you to make money on that tree if either those things do not happen you will lose money on that option purchase because as time passes the extrinsic value will come out of those options and at expiration an option will only be worth its intrinsic value in the case of the 355 Netflix call option if Netflix is at 350 8.19 that 3:55 call option has three dollars and 19 cents of intrinsic value because the share price of 350 819 is three dollars and 19 cents above the call as a strike price which means the remaining value or ten dollars and 86 cents of that options value is completely extrinsic now as time passes and the options expiration date approaches the option will slowly lose all of its extrinsic value leaving only the intrinsic value at expiration so if I buy this Netflix call option for 14.5 cents and in 29 days Netflix is still at the same price of three hundred and fifty eight dollars and nineteen cents that 355 call option will only be worth three dollars and 19 cents which means I will lose ten dollars and 86 cents on that option which means I actually lose one thousand and eighty six dollars on that option purchase for every contract that I bought for the 355 call option purchased for $14 and five cents to break-even at expiration meaning the options value is the same at expiration compared to what I purchased it for Netflix has to increase to three hundred and sixty nine dollars and five cents which comes from the fact that if I buy the three fifty five call option for $14 and five cents for that 355 call option to have $14 and five cents of value at expiration Netflix needs to be 14.5 cents above the call strike price when that call option expires and 355 plus the purchase price of $14 and five cents gives us a breakeven price of three hundred and sixty nine dollars and five cents in short if I buy the 355 call option for $14 and five cents and Netflix is currently at three hundred and fifty eight dollars and nineteen cents I need Netflix to increase over ten dollars for my position to just break even at expiration which means I don't make or lose any money if Netflix does not increased by that amount my call option will be less valuable at expiration compared to what I paid for it in which case I will have a loss at expiration so when buying options you need a favorable stock price movement in a short period of time to make money on that trade otherwise you're going to lose money to the passage of time because as passes extrinsic value comes out of options and when you're buying options the decrease in the extrinsic value will work against you as an option buyer when it comes to selling options everything that I just mentioned is reversed using Netflix again as our example let's look at an option selling strategy so that we can compare the differences between buying options and selling options for the options selling strategy let's look at selling the Netflix put option with a strike price of three hundred and fifty dollars that has 29 days to expiration in this example Netflix is at three hundred and fifty eight dollars and twenty one cents at the time of recording this options price the 350 put option was trading for seven dollars and ninety cents or seven hundred and ninety dollars in premium when selling options the most you can make on an option trade is the difference between the price that you sell the option for and zero dollars because the best-case scenario as an option seller is that the option is worthless at expiration in the case of this 350 put option that is currently trading for seven dollars and ninety cents if at expiration the put options value is zero dollars as the option seller I will profit by seven hundred and ninety dollars since if I sell an option for seven dollars and ninety cents and it expires worthless my profit on that trade is going to be seven dollars and ninety cents on the option which as we know due to the contract multiplier of 100 the actual profit would be seven hundred and ninety dollars for every put option that I sold when buying options you adopt a buy low sell high mentality which means that your goal when buying an option is to later sell it for a price that is more than what you paid for that option when selling options you adopt a sell high buy low mentality which means as an option seller your goal is to buy back the option for a price that is less than what you collected when selling that option and in the ideal scenario the option price is zero dollars at expiration which means that option is worthless and you keep a hundred percent of what you sold the option for so we know that if I sell this 350 put option on Netflix for seven dollars and ninety cents the most I can make is seven hundred and ninety dollars per put contract that I sell but how much can I lose in this same trade when selling a put option the worst case scenario that can happen is the stock price goes to zero in which case that put option will be worth the strike price so in the case of this put option with a strike price of 350 dollars if Netflix went to $0 the 350 put would be worth 350 dollars which would mean the option is worth $35,000 now since I sold it for 790 dollars if its price increased to $35,000 I would have a loss of thirty four thousand two hundred and ten dollars and that's on one contract but as we know it's very unlikely that a stock is gonna go out of business and go to zero dollars in such a short time period such as 29 days but the key here is that when you sell options the risk that is taken is typically far more significant than the amount of reward potential that you have so in the case of buying the Netflix call option the maximum loss potential was fourteen hundred and five dollars while the profit potential is theoretically unlimited but in the case of selling this 350 put option on Netflix the maximum profit potential is seven hundred and ninety dollars and the maximum loss potential is thirty four thousand two hundred and ten dollars so very different in terms of risk and reward which brings us to the first major difference between buying options and selling options and that's that when you buy options typically the amount of money that you can make far exceeds what you can lose on that trade and when you're selling options typically the amount you can lose far exceeds what you can make on that trade the second major difference is that as I mentioned when buying the call option Netflix has to increase otherwise the trade will lose money to the loss of extrinsic value as the option approaches its expiration date in the case of selling the 350 put option on Netflix Netflix does not have to go anywhere for the position to make money which means that as an option seller I don't need anything to happen to make money and as an option buyer I need something very favorable to happen in a short period of time to make money let's go over these points once more using the Netflix trades that we just looked at in the previous examples with Netflix at three hundred and fifty eight dollars and twenty one cents when selling the 350 put option for seven dollars and ninety cents a hundred percent of that 350 puts value is extrinsic because put options only have intrinsic value when the stock price is below the put strike price and if Netflix is at 5821 the 350-foot option has no intrinsic value which means the seven dollar and ninety cent cost of that option is 100% extrinsic now that means that if time passes and Netflix does not decrease significantly that 350 put options value will steadily go from seven dollars and ninety cents towards zero dollars and if Netflix is above three hundred and fifty dollars at expiration that 350 put option will expire worthless and me as the option seller will keep a hundred percent of the premium that I collected for selling that option even if Netflix does decrease Netflix could fall to a price of three hundred and forty two dollars and ten cents and I would still break even or make money on that three hundred and fifty foot that I sold and the reason for that is if Netflix is at three forty to ten at expiration the three fifty put option will have seven dollars and ninety cents of intrinsic value and since that's the same amount that I sold the option for if at expiration the option is worth seven dollars and ninety cents I will have no profit or loss on that position which means I will break even so in short if Netflix is at three 5821 and I sell the three fifty put option for seven dollars and ninety cent Netflix could fall all the way to three hundred and forty two dollars and ten cents and I still wouldn't lose money on that trade at expiration when buying options since the risk taken is typically much less than the reward potential and because you need something to happen in a short period of time to make money buying options is a low probability trading strategy and that means in theory if you buy an option you have less than a 50% probability of making money on that trade when selling options since the risk that you have is typically far greater than the amount of profit you can make and due to the fact that you don't need anything to happen to make money on that trade selling options is a high probability trading approach which means in theory if you sell an option the probability that you'll make money on that trade is greater than 50% it's important to understand that everything related to options trading ties into probability the more reward potential relative to the risk taken the lower the probability of making money on that trade and basic options strategies such as buying call options buying put options or combining the two into other option buying strategies all of these strategies require a significant stock price movement in the favor of that strategy to make money otherwise the position will lose money to time decay on the other hand the more risk that has taken relative to the profit potential the higher the probability of making money on that trade and basic options strategies such as selling call options selling put options or combining the two to create other options strategies all of those strategies are high probability trading approaches because they can profit as long as time passes without a significant movement in the stock price against those positions the next major difference between buying options and selling options is related to exercise and assignment now when you buy an option you have full control over when you exercise the option or if you exercise the option which means you never have to worry about being assigned on that option as an option seller you have no control over when an option buyer will exercise that option and since you have no control over when that option is exercised as an option seller you will sometimes find yourself in a sin area where you get assigned shares of stock unexpectedly because somebody on the other side of that trade exercised the option and unfortunately you were chosen at random to be assigned the opposing share position as the person that exercised the option the next difference between buying options and selling options is that when you buy options the margin required to put that trade on is going to be equal to the maximum loss potential of that position so in the case of buying the Netflix call option from earlier if the maximum loss potential is one thousand four hundred and five dollars my margin requirement for that trade would be one thousand four hundred and five dollars now when selling options the margin required to put that trade on is typically going to be far more significant than buying an option because when you sell an option the brokerage firm has to account for potentially large changes against your position in which case you could lose immense sums of money which is why when selling options the margin requirement for putting on a particular trade can be quite steep so we've talked about the major differences between buying options and selling options but which approach is better if there is one well to be honest there really isn't one better approach as there are consistently profitable traders on the buying options side of things and there are consistently profitable traders on the selling options side of things more important than buying options or selling is that you have a detailed strategy and a plan that you're following to keep your emotions in check and to keep things consistent with that particular trading approach but I will mention some difficulties associated with each trading approach first when buying options since there's no limit to how much you can make it can be very difficult to decide when to sell your option and take the profits since there's no limit to how much the profit can grow to if you buy an option for $5.00 and you watch that option price go to $10 because the stock price moved in your favor you're probably going to be inclined to continue holding that position because you're anticipating that the stock price continues moving in your favor in which case you could make a lot more money than you've already made right now when it comes to selling options the more profitable the trade becomes the more logical and easy it is to take profits on that trade because as the trade gets more and more profitable you have less to make on the position but you still have all of the risk remaining for example if I sell an option for $5.00 or $500 in premium and the option price Falls to $1 I will have a gain of $400 on that position and with the option price at $1 if the most I can lose is another dollar or $100 in my favor which means I've already made 80% of the profit potential in which case it would be wise of me to close that position and take the 80% profits because I can only make another hundred dollars but I still have all of the risk on the table if things turn around and the stock price moves against my position now when it comes to holding losing positions when you're buying options it becomes easier and easier to hold a losing position because since you can only lose so much The Closer that option price gets to $0 the less you have to lose but you still have time left before the option expires which means that since you have little left to lose but everything left to gain it's very easy to hold that option in the anticipation of a reversal in the stock price which could potentially turn things around for you and leave you with a profitable option purchase when you're selling options if a position starts to move against you and you're down money on that trade it can be very tempting to close the position to cut your losses because since the loss potential is significant and you don't know how much the stock is going to continue moving against you it can become very difficult to decide when to close the position or when to keep holding it when you're selling options and losing trade when comparing the two trading approaches buying options and selling options do have their differences and it's important to consider all the difficulties associated with trading successfully from either one of those sides to quickly wrap up this video let's go ahead and recap all of the major differences between buying options and selling options that I've discussed in this video first option buying strategies typically have far more reward potential compared to the risk that has taken and when selling options the risk that is taken is typically far more than the reward potential for that particular strategy in order to profit when you're implementing option buying strategies you need a favorable movement in the stock price and or implied volatility in a short period of time to make money on that trade when selling options you can make money simply when time passes so long as the stock price does not move significantly against your position because of the fact that when you're buying options you need something favorable to happen in a short period of time buying options is a low probability trading approach which means in theory if you buy an option the probability that you'll make money on that trade at expiration is less than 50% when selling options since you don't need anything to happen to make money selling options is a high probability trading approach which means when you sell options in theory you have a greater than 50% probability of making money on that trade lastly those who buy options have full control over whether or not they exercise those options which means as an option buyer you never have to worry about unexpectedly being assigned a stock position whereas when selling options since you have no control over when or if someone exercises that option you might sometimes be assigned shares of stock unexpectedly in which case you'll have the opposite position as the person who exercised the option that's gonna do it for this video on buying options and selling options I really hope you enjoyed this video and learn something about the to trading approaches if you enjoyed this video please give it a thumbs up if you have any questions or comments leave them down below because I do respond to almost every single comment that is left on my videos once again I'm Chris from project option and I was [Music] [Music] [Music] you

Channel: projectfinance

Views: 118,938

Keywords: buying options vs selling options, buying options, selling options, why sell options, why buy options, options trading, options trading basics, stock market, finance, projectoption, tastytrade, call option, put option, trading, stock options, options trader

Id: -S4NICQNSEc

Length: 20min 3sec (1203 seconds)

Published: Thu Apr 25 2019