The derivatives market offers a variety of ways to achieve financial objectives. Traders can use options to speculate on directional trends, profit from changes in volatility levels, hedge existing positions against unfavorable price activity, and much, much more. In short, a person can customize his or her portfolio to benefit from any expected condition or outlook and adjustments can be made to effectively manage almost every situation that arises. This versatility stems from a very unique characteristic; leverage, which allows an individual to profit from market movement with a smaller capital outlay than would be required to purchase the underlying issue. However, when leverage is used to boost the potential return of an investment, there is also a resultant increase in cost or risk. This fact implies that one of the best ways to evaluate options trading strategies is to compare risk versus reward. Today, we'll begin the comparison process at the lowest level by looking at the difference between an option purchase and an option sale.
Understanding Differences in Risk
Like most financial instruments, an option is an asset with potential and liability. The influence of these characteristics varies, depending on whether the option is bought or sold. For the option buyer, the potential is great while liability is low. In contrast, the option seller typically has substantial liability with less potential. This relationship may seem unbalanced, but it's really not; the option seller normally enjoys a high number of successful outcomes while the option buyer experiences comparatively few winners. In addition, the option buyer always endures an out-of-pocket (cash) expense whereas the option seller can often fund his trades with portfolio collateral.
Here are the principal advantages and disadvantages of each strategy:
Obviously, there are broad differences between these two approaches thus a trader who is trying to select the appropriate options strategy for his portfolio must examine the reasons for each benefit and drawback. Since buying options is the more common tactic among retail options traders, we'll review that technique first.
An option is a contract related to a specific underlying issue such as a stock, index, exchange-traded fund, or similar product. The contract is very precise; it stipulates details such as rights or obligations, exercise price, and expiration date. When a trader buys an option, he is purchasing the rights of the contract with no obligations. Once the option has been purchased, the trader determines its future; he can allow the option to expire, exercise the privileges of the option, or sell the option in the open market.
The primary benefit of option ownership is the ability to control a specific quantity of the underlying issue for a fraction of its actual cost. Because of this leverage, a favorable move in the parent asset can produce an exponential percentage return for the option buyer with no risk beyond that which was paid for the option contract. Despite this valuable quality, the risk of option ownership is substantial on a relative basis because it is a wasting asset; the contract is exposed to time-value erosion every day it is in existence. This differs significantly from owning a stock or similar instrument, which has no expiration date. In fact, the passage of time has no direct effect on these types of issues but when an option expires, its rights no longer exist and there is no tangible value beyond that date.
Buying an option is a directional strategy therefore its success is based on correctly forecasting the future activity of the underlying instrument. Since the technique offers unlimited potential gain, the purchase of an option is particularly attractive for traders with less capital who want to speculate on a specific trend without risking all of the funds in their portfolio. Without doubt, the ability to achieve a large return with little investment is very appealing however it is important to remember that any outlay of funds for the purchase of an option represents an expense that must be recovered before a gain can be realized. In order for the option buyer to earn a profit, it is necessary for the price of the underlying issue to move both in a favorable direction, and in a manner that produces enough change in the option value to overcome its cost. This condition highlights the primary drawback to option ownership; it has a relatively low probability of success, due to the difficulty in predicting market movement and overcoming the (negative) effect of time-value erosion. Of course, there are other factors such as distance to strike, implied volatility, interest and dividend rates, etc., that can significantly influence the price of an option. Nonetheless, even when there is a complete understanding of these complex components, it's safe to say that very few option buyers will achieve success on a regular basis.
As you would expect, traders who sell (write) options have a completely different set of factors to consider. Selling an option yields a premium or cash inflow but it also results in an obligation that must be fulfilled upon request of the owner. A trader who writes a call option may be asked to sell the underlying interest and likewise, a trader who writes a put option can be required to buy the underlying interest, if assigned. With a short option, the seller has absolutely no control over the contract; it can be exercised at any time prior to the expiration date. However, just as the buyer can sell an option back to the market rather than exercising it, a writer can purchase an offsetting contract and terminate the obligation to meet the terms of the contract.
Similar to option buying, selling an option is primarily a directional strategy. The underlying issue must finish the expiration period beyond (above with puts; below with calls) the strike price of the sold option in order for the position to achieve maximum profit. Since this outcome is the only requirement for success, an option writer is not concerned so much with identifying where the price of an issue will go, but rather where the price will not go. Obviously, it is much easier to determine a price range for particular issue than it is to predict both trend and magnitude of movement. In addition, the option writer is not as concerned about volatility because the benefits of time-value erosion are working in his favor, thus he can be far less accurate in his forecast and still realize a gain. While an increase in volatility will have a negative affect on the value of a short option, the overall impact is not as significant for option sellers, which need only to avoid positions in which volatility is historically very low and/or expected to trend considerably higher.
As with the majority of option buyers, most option sellers focus primarily on the relationship between strike price and share value. However, the risk versus reward outlook established by the distance from the underlying instrument to the option strike is completely different for the two strategies. Whereas a speculative option buyer will typically gravitate towards out-of-the-money positions, an option seller would likely choose this category for conservative plays. In contrast, selling an in-the-money option is usually considered aggressive by experienced market participants while buying in-the-money options is most often promoted as a cautious approach. Since the overall success of the option writer is generally predicated on achieving consistent, small gains, the greater portion of retail traders sell out-of-the-money options, which have the lowest mathematical chance of being assigned.
Although an individual who writes options typically enjoys a high probability of success, any strategy involving uncovered options has unique risks. In some cases, the risk is theoretically unlimited though that outcome is impractical and rarely considered by experienced traders. Nevertheless, the amount of loss an option writer can realize is substantial therefore the obligation he assumes must be covered, either with cash, collateral or an offsetting instrument. This amount, in equity or other valuable considerations, is generally the basis for determining the potential profit in a short option position. A commonly used guideline for the minimum (or maintenance) margin is as follows:
For each short option, 100% of option market value plus 20% of underlying security value less out-of-the-money amount, if any, to a minimum for calls of option market value plus 10% of the underlying security value, and a minimum for puts of option market value plus 10% of the put’s exercise price.
The formula above is somewhat confusing in textual format but is actually very simple from a mathematical standpoint. In practical terms, it implies that a trader may initiate a short position with far less capital or portfolio collateral than would be required to make good his obligation in the worst possible scenario. This is the "real" risk – often overlooked – in selling options. In addition, the option writer's proceeds are generally very small when compared to the potential losses, thus one or two losing trades can negate a large number of profitable plays. Finally, it is possible in a market where prices are changing rapidly that an option writer may have little ability to control the extent of his losses. For these reasons, option writing as an ongoing portfolio strategy is absolutely inappropriate for anyone who does not fully understand the character and magnitude of the risks involved and who cannot absorb the adverse financial impact of occasional large losses.
Putting It All Together
Options are a necessary part of the financial markets because they provide an economical way for investors to speculate on future trends and manage portfolio risk. Despite their many benefits, options are not suitable for everyone, especially those who are unwilling to learn how they work and what risks are associated with particular strategies. Some people will do best with techniques that provide small, consistent returns, while others will achieve prosperity from the gains of a few "big" winners. Truly, it matters not how the profits are realized, but rather that the risk versus reward outlook is appropriate for a trader's particular financial situation and conforms to his or her individual investment objectives.