Option Buying vs Option Selling

Check Stock Market Education Topics

Options trading this term itself is enough to attract many traders in the market. But most of them stay confused whether to take a position as a buyer or seller. So, before you get into options trading, let’s have detailed understanding of option buying vs option selling.

But before getting into the detail, let’s understand option trading basics.

Options trading is a type of derivatives contract that gives the buyer a  right but not obligation to settle the trade on expiry.

Now, here the main term is option buyer who gets an option to settle the trade on expiry but what about option seller?

Option seller has an obligation to settle the trade on expiry and for this he earns premium in advance from the buyer.

Let’s now understand its meaning by understanding the difference between the two in detail.

Why is Option Selling better than Option Buying?

Let’s take a simple example to understand the concept of how option trading works and to understand the concept of option buying and selling.

Suppose you want to buy a flat. You visited one site and liked the flat which cost INR 60 lakhs but the flat would be ready to move in 6 months.

Now to sell the flat, the builder comes with an offer for you, where he offers to sell the flat after 6 months at the current market price i.e. 60 lakhs even if it price goes up.

But he puts one condition.

Condition?

Yes,  that you have to make a payment of ₹50,000/-

With this he gave you the option to buy the flat after 6 months only if the price goes above ₹60 lakhs. However, if the price goes down then you can opt not to buy that flat anymore.

In that case, you will not buy a flat and not get your initial capital ₹50,000/- back.

So, what understanding do you get from this example?

If the flat price increases from₹60 lakhs then you will be in profit which would be the difference in the actual value of the flat and buying value.

On the other hand, if the price drops then you will be losing ₹50,000/-.

The exact opposite happens with the builder who will gain ₹50,000 without selling anything if the price goes down and face unlimited loss if the rate of flat rises in 6 months.

This is what the story of option buyer and seller is where the buyer pays a premium and limits his loss to the premium itself.

Reading this, it seems like that option buyer makes more money in the market and suffers less loss, but the reality is the exact opposite.

It is the option seller that makes more money.

Confused again?

Let’s simplify this for you. Have you heard, high risk high return. In the above scenario who is taking more risk, buyer or seller?

Ofcourse seller, because his loss is undefined and profit is limited to the upfront capital called premium.

Hence there is less risk of losing money for option sellers in comparison to option buyers and hence makes selling better than buying for option traders.

Let’s discuss some more parameters which help in understanding option buying vs option selling which is better

1. Option Expires Out of the Money

You might have heard about ITM, ATM and OTM options. These options differ from each other in terms of premium value and risk involved.

So, if Nifty is trading at 21500 then 21000 CE would be ITM, 21500 CE ATM and 22000 CE would be OTM options.

Let’s suppose the premium for these options are:

Understanding these strike prices technically.

Buying 21000 CE

when Nifty is trading at 21500 simply means that you are paying premium to gain a right but not obligation to exercise this trade on expiry if the market closes above 21000. Now the market is already above 21000.

This increases the option trading risk at the sellers side and hence the premium is the highest for ITM options.

On the other hand, if you buy options 22000 CE, this means you are taking a position above the current market value which decreases the seller’s risk and hence premium value is the least.

Now option buyer often trade in cheap options i.e. OTM strike price. If the market closes below that strike price the buyer would lose the entire premium value.

So, if we consider that the market closes at 21900, the ITM option trader would be making some money and the same goes for the ATM call option buyer.

But the OTM call option buyer the option expires out of the money which means the buyer loses the entire premium capital. This makes option buying risky.

However, there are ways to minimise these losses.

Wondering how?

Let’s take you back to your school time. You often used to focus on one subject more than the other.

Why did you and most of the other students in their school days do so?

Because, the weekly test and exams report card helps you to know where you were lacking. What if you get similar insights for your trades as well, where you can calculate your probability success ratio by analysing your past trades.

This is now actually possible with the My Trade Story feature of the Samco trading app which shows you the Andekha Sach of your trades.

With this feature, you would be able to calculate the strike rate on the basis of the average gain and loss trades done in the past.

If the strike rate value is less than 1, this depicts that your loss is higher than profit. In such a scenario, this feature provides you actionable insights that helps in increasing your overall trade score and profit in trading.

 


2. Theta Decay

Let’s consider a fruit vendor to understand the concept of theta decay. Suppose a fruit vendor bought some bananas to sell in the entire day.

In the morning, he sold bananas at the rate of ₹100 per dozen. As the day passed by, he sold bananas at ₹60 per dozen and later at night he sold all the remaining bananas at ₹40 per dozen.

Why did he do so?

Because banana is a perishable fruit which gets spoiled another day making its value zero.

You can consider options similar to the above case. Like bananas they too come with an expiry which depreciates its value with each passing day.

So, if you buy an option contract at ₹100 on Monday, its value will depreciate a bit on Tuesday and eventually comes to 0 on expiry.

An option buyer who takes a long position in an option has to suffer loss because of this time factor called theta decay.

On the other hand, theta decay becomes the best way for sellers to earn profit. This profit increases to many fold if the market moves sideways.


3. Implied Volatility

Another important parameter that is important to understand option buying vs option selling is implied volatility.

It is the value that helps a trader in predicting the future volatility of the market and this value often increases in case of events, news and announcement.

With the increase in implied volatility premium value increases to many fold but the sudden decrease in IV decreases the premium as well which becomes the major loss for option buyers.

To understand this, let’s consider that you bought an option contract at ₹5000 on the day when the budget was announced. The IV was high.

You thought of keeping the option overnight but the impact of budget died soon and on the very next day premium was reduced to ₹3000.

Thus, the chances of buyers losing money increases with the sudden drop of IV as well, which makes it riskier than option selling.

Considering all the above parameters, it is clear that option selling is better than option buying.


Difference Between Option Buying and Option Selling

Option buying requires less money but is riskier than option selling. On the other hand, option sellers make less profit but limit their losses.

There are a few more differences which are explained in the table below:


Conclusion

 If you want to begin your trading journey in options then it is important to understand the major concepts of Option Buying vs Option Selling.

On considering the risk and reward of both option buying and selling, you will know is pros and cons of options trading which eventually make easier to take the right position in the market.

It is always advised to start small and learn the concept of trading before investing your hard-earned money in the market.

So, keep exploring and learn to minimise losses in the market.

Just fill in some basic details in the form below and a callback will be arranged for you:

Open Free Demat Account
Enter basic details here and a Callback will be arranged for You!

More on Share Market Education:

If you wish to learn more about options trading or the stock market in general, here are a few references for you:

Add a Comment

Your email address will not be published. Required fields are marked *

seven − five =