There are many schools of thought when it comes to options and the best way to trade them. Of course, how you use options will depend on your trade objectives. An options trade designed to hedge a position in the underlying may be very different from an options trade designed to take advantage of a range-bound market.
It is important to keep in mind that trading is a game of odds. As an options trader, you may look to construct positions with the greatest odds of success. When it comes to selecting an options strategy, one must consider the differences between buying options and selling options.
Options Strategy: Buying Options
When you are net long options, whether a single call or a put spread, you have to be right about not one but three factors:
- Market direction: If you buy a long call, to make money the market will have to move higher or see an increase in implied volatility.
- Implied volatility: When you are long options, a decrease in IV can have a negative effect on your position. To have a profitable trade, you must also forecast implied volatility levels.
- Time: Because all options have a finite lifespan, you not only have to be right about direction and IV, but you also have to be right about the timing of such a move.
Many options traders know what it feels like to be right but still lose money. Sometimes, a market makes the anticipated move right after your long options have expired. In other cases, an options trader may buy a put with a very elevated IV level, and lose money if IV levels decline.
Options Strategy: Selling Options
When selling options, the above factors work quite differently:
- Market direction: The market can move against your position, but you may still potentially profit if the market remains above the breakeven level at expiration.
- Implied volatility: While an increase in IV may hurt your position, a decrease works in your favor. And although an increase in IV may cause losses on paper, the effects of time decay may potentially offset some of these losses. If the options are out of the money at expiration, they will expire worthless regardless of IV levels and may potentially produce a profit.
- Time: The clock is an option seller’s best friend. Because options lose value with the passage of time, the option seller may potentially profit from theta all other inputs remaining constant.
In our opinion, the highest odds of a successful options trade may be had by not forecasting where a market will go, but rather where a market is not likely to go. For example, do you think it is more likely for the SP500 in a given month to rise by five percent or decline by 15 percent?
This is not to say that you should go out and start selling options. Option selling can be extremely risky and is not suitable for all investors. Also, option selling can carry with it extensive market exposure and therefore unlimited loss potential. Many a trading account has been wiped out or worse in this fashion. There are ways, however, to quantify risk when selling options. A put spread, for example, carries risk limited to the difference between strike prices minus the net premium collected.
A short, limited risk put spread, for example, may potentially put the power of time in your favor and may require a significant adverse market move to produce a loss. If you are looking for a winning options strategy AKA some high-odds option plays, a defined-risk call or put spread may be worth considering.
