Three Big Reasons Why You Should Sell Options
Three Big Reasons Why You Should Sell Options
Sophisticated options traders: Quiz yourself. Can you name the three ways?
- An options buyer can make money only through directional bias and volatility changes.
- An options seller can make money through directional bias, volatility changes and the passage of time.
- Empirical results have shown implied volatility is routinely overstated, relative to the actual move that materializes in the market.
There are really only three ways to make money from options: direction (delta), time (theta) and volatility (vega). Yes, interest rates and dividends factor into this equation, too, but the interest rate impact is often negligible and not all stocks pay dividends. So, keeping our focus on the three main drivers makes sense.
The two sides of the contract
At trade entry, remember you have only two possible options in regard to the options contract itself. You get to decide which side of that contract you want to be on. You can choose to be the long side, or you can choose to be the short side. Well, here is the most compelling case I could ever make for why choosing the short side is the superior option for long-term consistency.
If you choose to buy the option, take the long side. Recognize you can make money in only two of the three possible ways: direction and volatility. You can get the directional move right or you can benefit from volatility expansion. Both scenarios lead to higher option prices—what you want as an options buyer. But the third profit driver, time, always works against you. You will never be able to turn theta into a positive, for your position’s p/l - that is the price you pay for unlimited profit potential.
Conversely, if you choose to sell an option, take the short side, and you can make money all three of the possible ways: direction, volatility, and time. A directional move in your favor will help you. A volatility contraction will help you. And the simple passage of time will help you. All three profit drivers are open to you as compensation for having to bear the added risk of unlimited risk.
Overstated implied volatility
Here is a direct quote from The Unlucky Investor’s Guide to Options Trading: “Historical Data show that perceived uncertainty in the market (IV) tends to overstate the realized underlying price move more often than theory suggests.”
So, in other words, implied volatility (IV) might be pricing in a $12 move, but on average that move is only $10. Or IV might be pricing in a $25 move, but on average that move is only $15. And so on. Well, options prices are always priced according to IV. That means if IV is routinely overstating the actual moves that materialize in the market, then option prices must be higher than they “should be.”
If they were priced more accurately with regard to what the market tends to do on average, then they would be lower than they are, but they aren’t priced lower. As a result, options sellers can take advantage of these higher prices, whereas options buyers cannot.
Jim Schultz, a quantitative expert and finance Ph.D., has been trading the markets for nearly two decades. He hosts From Theory to Practice, Monday-Friday on tastylive, where he explains theoretical trading concepts and provides a practical application of those concepts to a trading portfolio. @jschultzf3
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Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.