If you have ever tried to purchase a stock option and accidentally selected to sell an options contract, you likely already understand the distinction between buying vs selling options. There is a difference between the two that traders need to be aware of when developing their trading strategy. This article will discuss the difference between buying and selling options and the types of trading techniques used for each.
What is an Options Contract?
Options are a derivative of stocks and can be traded similar to them. Since they are a stock derivative, their value is affected by the movement (increase or decrease) in a stock’s price. One options contract can control 100 shares within a stock. Many traders take advantage of the leverage that options provide to capitalize on without spending the money necessary to buy 100 shares of a stock.
In addition, options can also be purchased and sold to hedge a portfolio against market crashes and declines.
Check out this article for further details on options contracts.
From a high-level overview, an options contract is when two parties agree that a stock will be purchased for a predetermined price and by a specific date (expiration date).
For example, let’s say you decide to purchase an options contract on SPY for a strike price of $400 (the predetermined price) with an expiration date of Friday, 5/27/2022. As the contract buyer, you would agree to have the right to buy 100 shares of the stock for $400 each.
When you decided to purchase the contract, the cost was $1.00 for the 100 shares that each contract covered. So, you bought the contract for $1.00 x 100 shares x 1 contract = $100, your out-of-pocket cost for the agreement.
The options seller or the writer sells you the contract on the opposite side. That seller would be the party on the other side that collected the $100 from you to purchase the contract.
The easiest way to think about options is to think of them, like home or car insurance premiums. The insurance company (“the seller”) will write the contract that stipulates the terms of the insurance and when the insurance coverage expires (similar to the options strike price and expiration date). To finalize the agreement, the insurance company will obtain the annual premium from you (“the buyer”).
Like insurance, options can act as a way to protect stock portfolios due to negative market news, company earnings reports, etc. In many cases, long-term investors purchase options like the home insurance example to hedge against any catastrophic events that could occur.
Two Types of Options Contracts
Two types of options contracts are available for trading (calls and puts).
A call option is when the option buyer is looking for the underlying stock price to move higher or at least be higher than the strike price (the predetermined price) by the time the options contract expires.
For the put contract, the buyer expects the stock to move lower than the strike price when the options contract expires.
Many day traders and swing traders who trade options do not hold them until their expiration date but buy and sell them before the expiration date to provide consistent income.
Buy to Open vs Sell to Open
Let’s discuss the difference between buying to open vs. selling to open a call or a put.
In general, when we buy to open (BTO) or sell to open (STO), we are opening a position between a buyer and a seller.
Buy to Close (BTC) or sell to close (STC) means closing out an existing position between a buyer and seller.
Buying Options Simplified
Buying Call Options
When buyers buy to open a call position, they expect the stock price to move upward equal to or higher than the strike price by the expiration date. The seller collects the premium from this buyer.
If this buyer does not sell back their options contract before the expiration date (sell to close), then that buyer will have the right to purchase 100 shares of the stock if the stock price has at least moved to that predetermined price (i.e., the strike price).
However, the buyer can choose to close out the contract and collect any profits made from the increase in the premium originally paid prior to the expiration.
Buying Put Options
When a buyer buys to open a put position, they expect the underlying stock price to move down equal to or lower than the strike price by the expiration date. The seller collects the premium from this buyer.
If this buyer does not sell back their options contract before the expiration date (sell to close), then that buyer will have the right to obligate the seller to purchase 100 shares of the stock from the buyer if the stock price has at least moved below that predetermined price (i.e., strike prices)
However, the buyer can choose to close out the contract and collect any profits made from the increase in the premium originally paid prior to the expiration.
Many day and swing traders do not buy puts or calls with the expectation that they will hold them until expiration. Thus, they never exercise the right to purchase shares or relinquish any existing shares owned.
Instead, they try to make money from increases in the value of the options contract based on the stock movement. Thus, if the position is closed out before the contract expires, the puts or calls buyer does not need extra capital to cover 100 shares of the underlying stock. One important rule for day traders and swing traders who do not want to own any stocks traded with options is that they ensure all positions are closed before expiration.
Selling Options Simplified
With sell to open (STO), the trader is opening sell positions first and then buying back the contracts later.
Selling Call Options:
When a seller sells to open a call position, they could expect the stock price to move sideways or possibly not move higher than the strike price by the expiration date.
The seller opens the position and collects the premium from this buyer. If this seller does not buy back their options contract before the expiration date (buy to close), then that seller will have the mandatory obligation to relinquish 100 shares of the stock if the stock price has at least moved to that predetermined price (i.e., strike price).
The seller of the call options contract would be expected to release 100 shares if the stock has moved above the strike at expiration. If the strike or pre-determined price was $350 and the stock’s price at the time of expiration was $400. Then, the seller would release 100 shares at $350 (even though the stock price is now worth $400).
Selling Put Options
When a seller sells to open a put position, they expect the stock price to move sideways or not to fall below the strike price by the expiration date. The seller collects the premium from this buyer.
If this seller does not buy back their options contract before the expiration date (buy to close), then that seller will have an obligation to purchase 100 shares of the stock if the stock price is below that predetermined price (i.e., strike price)
Selling puts and calls require that the trader have enough capital or margin to cover 100 shares at the strike price (selling puts) or own 100 shares of the stock (selling calls). The capital requirement is why most entry-level traders buy and do not sell options.
Buying vs Selling Options Strategies
A trader can use multi-leg options strategies like spreads and iron condors, which would allow buying and selling calls or puts simultaneously at one time. However, to keep things simple for beginners and intermediate traders, here are some one-leg straightforward approaches.
1. Buy Calls & Puts: Directional Trades
Many traders will place simple directional trades where they buy puts or calls depending on the direction they anticipate the stock to move. Rather than holding these option trades until they expire, these traders would take advantage of the price moving in one direction and sell out of the position for the profit gained from the option premium initially used for the purchase.
The drawdown to this approach is picking the wrong direction that you feel the stock is moving to and losing the option premium that was initially provided.
Many other traders will buy puts and calls to hedge against a market decline or correction. Investors who own shares in a company may decide to buy a put if they feel their share prices would be declining instead of ultimately selling out of their stocks. These investors and traders could still make money if the stock price dropped, and it would also allow them to continue to hold the shares.
2. Sell Options: Covered Calls
This strategy works for those traders who already own 100 or more shares of the same stock. Many of these traders will decide to sell to open a call options position and collect a premium from the buyer.
If the stock does not reach its strike price by the expiration date, these sellers get to keep the premium and will continue to hold their 100 shares of that stock. If the stock reaches its strike price by the expiration date, these sellers will still keep the premium. However, they will have to release 100 shares of that stock at the predetermined price to the buyer.
The drawdown to selling covered calls is that the seller could lose the opportunity to capitalize on a significant upward swing of their stock. For example, if the covered calls seller sold an option at a strike price of $150 and that stock jumped to $200 overnight. The covered calls seller would still collect the premium they earned from selling the covered call. However, they lost out on the price movement to $200 and would be obligated to hand over 100 shares at $150.
Conversely, if the stock dropped from $150 to $140, the covered call seller still kept the premium, and they would continue to hold on to their 100 shares.
Selling covered calls is a strategy used by many to generate consistent income on long-term stock shares.
3. Sell Options: Cash Secured Puts
Selling cash-secured puts is another strategy some traders use to generate income. In this case, the trader will decide to sell to open a put options position and collect a premium from the buyer.
If the stock stays above the strike price by the expiration date, these sellers get to keep the premium. If the stock drops under the strike price by the expiration date, then they retain the premium, but 100 shares will be “put” to them or assigned to them. Thus, they will automatically purchase 200 shares of the stock at that strike price.
This process requires that the seller would need to have an initial investment to cover 100 shares of that stock at the predetermined price. However, the put seller would still keep the premium earned from the sale of the options contract.
Traders use this strategy to obtain 100 shares of a stock at a specified price while also collecting a premium from the buyer. Some other traders use this strategy to collect premiums from the buyers and try to avoid assignment of the stock shares.
Summary of Why You Should Be Buying vs Selling Options
The above article provides a high-level depiction on the differences between buying vs selling options. In our strategy, we primarily buy calls and put options and place directional trades based upon this. This requires very little capital investment and we do not take on the risk required with selling options. The difference between buying and selling lies in the difference between “right” and “obligation.”
Since we are day traders, we never hold overnight and close out all our positions the same day so that we avoid any form of options assignments.
Check out this free 1-hour webinar where we teach you our proven strategy in trading options and learn how to trade them the easy way.
Also download a ( FREE E-BOOK ) by Maurice Kenny DAY TRADE LIKE A MILLIONAIRE.
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