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Options are one of the most popular investment vehicles for traders. However, the terminologies can get confusing for newcomers.
One such area of confusion is differentiating between selling and buying options, so what’s the main difference?
Selling options means you have an obligation to sell (selling calls) or buy (selling puts) a specific stock at a certain strike price. The difference in buying options is that you have the right to buy (buying calls) or sell (buying puts) a specific stock at the stipulated strike price.
When you sell a call or put you are obligated to act if the buyer wants to exercise their call/put. That means that you have to sell or buy the shares.
However, when buying a call or put you have the option to buy or sell the shares but you don’t have to.
In the rest of the article I will cover all the basics that you need to know about buying and selling options.
Main Difference Between Selling and Buying Options: Obligation vs Right
When selling options, you can either sell calls or sell puts. A call seller has an obligation to sell the stock at the strike price, while a put seller has an obligation to buy the stock at the strike price.
When buying options, the call buyer has the right but no obligation to buy a stock at a specific price, while the put buyer has the right but not obligation to sell a stock at a specific price.
The counterparts for the four types of options trades have to match up for a trade to be executed.
So, let’s assume that the call seller and put seller are Mrs. A and B, respectively, and the call buyer and put buyer are Mrs. C and D. For a trade to get executed, Mrs. A and C have to match up while Mrs. B and D have to match up.
All of this is done automatically through a system of brokerages and market makers.
A call or put buyer will have to pay premiums to a call or put seller.
The key difference to keep in mind is that the sellers have the obligation, while the buyers have the right. However, a seller’s obligation only kicks in if the contract is assigned on or before the expiration date.
The Difference In Market Expectations Between Buyers and Sellers
A call buyer expects the price of a stock to rise while a put buyer expects the price to fall. A seller of a call expects the price to fall or remain in a range at most.
So, when you sell a call, you believe the stock price will go down or stay the same, while the buyer on the other side believes it will rise.
On the other hand, a put seller expects the stock price to rise or stay the same, while the put buyer wants (and expects) the price to fall. So, if you believe a stock will decline significantly over a specific period, you can buy a put option to take advantage of the impending fall.
How To Decide Whether To Buy or Sell Options
Some traders suggest that options sellers outperform options buyers 60% of the time, but should you always be a seller? When is the right time to be a buyer?
Below are some considerations to guide you.
Check if the Option Is Overpriced or Underpriced
To decide if an option is overpriced or underpriced, you have to calculate the intrinsic value. However, calculating the intrinsic value of an option isn’t as straightforward as how it’s approached in equities.
You’ll need to use a model known as the Black & Scholes model for your calculation.
Most options brokers have the model on their platform, so you don’t need to worry about the formula. You just need to plug in the options to run the calculation.
You should sell options above the intrinsic value as they are overpriced. Options below the intrinsic value are underpriced and should be bought.
Confirm the Direction of Volatility
Volatility affects both call and put options. The value of an option tends to go up when volatility is up. It’s best to sell options at this point.
If volatility is trending downwards, you should buy options. However, the challenge is knowing when the market is about to be least volatile or when it will kick up significantly.
Many traders believe the summer months are most quiet, making it a self-fulfilling prophecy. However, December is also a fairly quiet month. This research points at the three months from September to November as the most volatile on the flip side.
Check for Major Events With a Strong Impact on the Market
You should buy options before important geopolitical or economic events that can strongly impact the market.
As a buyer, you’re only at risk of losing the premium paid for the options. As a seller, there is the risk of losing considerably more. Examples abound of traders who sold options just before key significant events, losing billions in the process.
Listen to Technical and Fundamental Analysis
What’s your technical analysis on the medium-term movements of the underlying stock? Do you expect the stock to retrace at a key support or resistance level, or do you envisage a decisive break? Your bias here should help you decide whether to buy or sell a specific option.
Similarly, suppose you’ve read some reports about the company or expect their quarterly earnings calls to miss or beat expectations. In that case, you can decide to buy or sell options depending on your leanings.
Check the Time Left to Expiry
The time to expiry is an important factor to consider when you’re buying or selling an option. All option contracts have a specific date of maturity. In most cases, time favors option sellers more than buyers.
The time decay on an option accelerates faster as the expiry date nears, while it’s more stable at the start of the option sale. So, you should avoid buying options closer to expiry unless you’re convinced about volatility or you want to make a well-informed bet.
Options sellers have an obligation to sell or buy stocks at a strike price, while buyers have the right to buy or sell stocks at the strike price. Understanding the distinctions will improve your chances of success as an options trader.
Once you understand the differences, your attention should switch towards making sure you’re on the right side of the option trade most of the time.