Should You Buy Or Sell Options – Long vs Short

Today’s lesson is all about comparing buying to selling options. Buying options to open (or going long) and selling options to open (or going short) are two completely different things for different purposes. But many options trading newcomers are unaware of these differences. Every successful option trader needs to know how buying options is different from selling options. Therefore, this lesson will walk you through all the major differences between buying and selling options.

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Video Breakdown

The video lesson below also covers the topic buying vs selling options. I recommend reading the article and watching the video for the best learning effect.

 

 

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The Differences between Buying and Selling Options:

A long call is a bullish strategy and a short call is a bearish strategy. Therefore, option trading newcomers often think that a short call is very similar to a long put as both these strategies are bearish. But this is not the case. Buying a put option is not an adequate alternative to selling a call option.

These are two very different strategies suitable for two very different market scenarios.  Therefore, these shouldn’t be used in the same way.

One main difference between an option buyer and an option seller is the right vs the obligation:

• A buyer of a Call option has the right to buy the underlying stock at a certain, predetermined price.

 

• A seller of a Call option has the obligation to sell the underlying stock at a certain, predetermined price (if the buyer exercises his right).

 

• A buyer of a Put option has the right to sell the underlying stock at a certain, predetermined price.

 

• A seller of a Put option has the obligation to buy the underlying stock at a certain, predetermined price (if the buyer exercises his right).

 

It is very important to understand that a seller has no choice because he is obligated to deliver/accept shares of the underlying stock if the buyer chooses to exercise his option. A buyer, however, has the choice to exercise his right.

(American options can be exercised whenever their owner chooses to. European options, on the other hand, can only be exercised on the expiration date.)

 

Besides the just discussed difference, there are plenty of other important differences. To present these differences, I will break down buying and selling options one by one now.

 

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Buying Options (Long):

Market assumption:

When buying options, whether calls or puts, you should have a certain directional assumption for the underlying asset. To make money on long positions the price of the underlying has to move in your direction no matter what strike price you choose. Therefore, you either have to be bullish or bearish. The further you buy an option out of the money (OTM), the more the underlying’s price has to move for this option to become profitable. But because of the unlimited profit potential, the further the underlying’s price moves in your direction, the more profitable it will become.

Setup:

• Buy 1 Call

or

• Buy 1 Put

Just like the name implies, buying options does cost money and requires you to pay. Ideally, this option can later be sold for more than it was initially purchased for.

Profit and Loss:

Long option positions have a defined risk and an undefined profit potential. This means your max loss is limited, but your max gain is theoretically unlimited.

• Maximum Profit: Unlimited

 

• Maximum Loss: Net Premium * 100

(A standard option contract controls 100 shares of the underlying asset. Therefore, you normally have to multiply the quoted option’s price by 100 to receive the amount that you have to pay for 1 option contract.)

• Break-even Point: Strike Price + Premium Paid (for calls) and Strike Price – Premium Paid (for puts)

(Break-even Point: The position achieves a profit if the underlying’s price moves and stays beyond this price point until the expiration date.)

• Example: XYZ is trading at $60. Peter buys 1 call option at the 50 strike price for $14 (*100). The max profit of this position is unlimited. The max loss, however, is $1400 because Peter paid $1400 to open this position. His break-even point, therefore, is $64 ($50 + $14). As long as XYZ’s price moves up and stays beyond $64 until the expiration date, Peter will end up with a profit.

 

Implied Volatility and Time Decay:

Long option positions have a positive Vega-value meaning that they profit from rising Implied Volatility. This means it is best to buy options in times of low IV (IV rank under 50). Doing this will allow you to profit from an increase in IV.

Time Decay doesn’t work in favor of long option positions. Therefore, the option Greek Theta is negative for long option positions. This means that the bought option loses some of its value every day. The closer the position is to its expiration date, the more value it will lose every day.

Summed Up

Summed up you can say that long option positions are directional bets. The underlying asset’s price always has to move for a long option position to become profitable. This is somewhat similar to stock trading. But a big difference for options is that the underlying asset has limited time to move in the desired direction. If the underlying’s price does not move enough, the option will expire worthless.

A common use of long option positions is hedging. Hedging is a way of protecting positions from extreme moves. For a better understanding, I will explain this with a brief example:

Let’s say you bought 500 shares of ABC a few years ago. Currently, ABC is trading at $200 and back when you bought the shares ABC was trading at $100. So you have a solid gain in this position. Nevertheless, you still don’t want to sell the shares as you still believe in ABC. However, you are scared of a potential market crash or similar bearish event. Therefore, you buy 5 contracts of ABC put options at the 195 strike price. Doing this will limit your downside risk until the options expire.

If ABC’s price would fall dramatically, you still wouldn’t lose too much money. Let’s say ABC’s price falls down to $170. As you bought the put options, the losses from your stock position are offset by the gains from the option position.

The 5 put options give you the right to sell 500 shares of ABC for $195 per share. Therefore, you could close your stock position for $195 per share even though ABC is trading at $170.

 

Hopefully, you can see how buying options can protect you against big moves in unwanted directions. It is also possible to use long option position as hedges for short option positions. But more on that in the next lesson.

Besides hedging, long option positions are mainly used as directional bets. For example, if someone expects a very big up-move in an underlying, he may choose to buy X contracts of call options.

Due to its very directional nature, a long option position usually has a rather low probability of profit (POP). This is another important factor to consider when trading options.

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Selling Options (Short):

Market assumption:

Short option positions are a little more versatile than long option positions. You don’t necessarily have to have a certain directional assumption when selling options. Your directional assumption could be slightly bearish, slightly bullish or even neutral… When selling options, the underlying asset usually has some room to move in before your position starts to lose money. The further Out of The Money (OTM) you sell options, the more room the underlying asset’s price has to move in. But even if you sell an ITM option, you leave some wiggle room for the underlying asset’s price.

Setup:

• Sell 1 Call

or

• Sell 1 Put

When you sell an option to open a position, you will receive money. The goal is to buy back the option position for less than you initially received for it.

Selling an option without owning the underlying asset is also referred to as trading ‘naked’. So a naked call is simply a standalone short call position. A naked put is a standalone short put position.

Profit and Loss:

Selling naked options is an undefined risk and defined profit strategy. In other words, your risk is unlimited but your profit potential is capped. (Naked puts have a defined risk as the underlying’s price can only fall to $0. But naked calls are undefined risk strategies as the underlying asset’s price theoretically can increase infinitely.) Even though this might sound scary, it really isn’t that bad. This should not be a reason to avoid options selling. There are multiple ways to protect yourself against big losses when selling options (one way is hedging with long option positions). Furthermore, most assets won’t suddenly drop to $0 or rise to infinity anyway.

Maximum profit is achieved as long as the underlying asset’s price does not move and stay beyond the strike price of the sold option until expiration (for OTM options).

• Maximum Profit: Premium Received (*100)

(A standard option contract controls 100 shares of the underlying asset. Therefore, you normally have to multiply the quoted option’s price by 100 to receive the amount that you have to pay for 1 option contract.)

• Maximum Loss: Unlimited

 

• Break-even Point: Strike Price + Premium Received (for calls) and Strike Price – Premium Received (for puts)

(Break-even Point: The position achieves a profit if the underlying’s price does not move and stay beyond this price point until the expiration date.)

• Example: ABC is trading at $320. Julia decides to sell a put option at the 310 strike price for $2 (*100). This means the max achievable profit on this position is $200 as this is what Julia received for selling the option. The max loss is theoretically unlimited. The break-even point is $308 ($310 – $2) which means that Julia’s position will be profitable as long as ABC’s price stays above $308 until the expiration date.

 

Implied Volatility and Time Decay:

Options tend to be more expensive in times of high IV. Therefore, short option positions profit from a drop in Implied Volatility (the Vega-value for short option positions is negative). This means it is best to sell options in a high IV environment (IV rank over 50). Doing this will give you the chance to profit from decreasing IV.

Time Decay does work in favor of short option positions. So short option positions have a positive Theta-value. The sold option loses some of its value every day which is great for option sellers (as they want to buy back the option for less than they sold it for). Once again, Theta increases, the closer an expiration gets to its expiration date.

Summed Up

Different from long option positions, short option positions are not directional bets. Actually, they are the exact opposite! Option sellers can be compared to casino owners. Both sell things that are likely to become worthless or at least close to that. An option seller hopes that his sold option will expire worthless so that he can keep the entire credit collected.

Option selling, therefore, is more versatile than option buying. An option seller mostly has a much higher probability of profit (POP) than an option buyer. This is because an option seller does not have to predict big price movements in the underlying asset. An option seller simply bets that the underlying asset’s price will stay within a certain range until the expiration date.

Nevertheless, option selling also has some disadvantages to option buying. In the following segment, I will discuss some of the advantages and disadvantages of options buying and selling.

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Pros and Cons of Buying vs Selling Options:

Selling Options:

Pros 

• Versatility
• The underlying asset’s price has some room to move in
• High probability of profit (POP)
• Time decay works in favor of short option positions

Cons

• The obligation to deliver/accept shares of stock (if the option buyer chooses to exercise his right)
• Defined profit potential
• Undefined risk (for naked options)

Buying Options

Pros

• The Right to exercise your option(s)
• Defined risk
• Undefined profit potential

Cons

• Directional bets (the underlying’s price has to move enough in a certain direction)
• Low probability of profit (POP)
• Time decay works against long option positions (they lose some of their value every day)

 

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Trading Strategies

Both option buying and option selling have their advantages. Therefore, it can be hard to pick one. Luckily, you don’t have to! As I discussed in a previous lesson, different options can be combined to create option strategies. When you combine long and short option positions, you can take advantage of the pros of both selling and buying options.

For example, a very popular option strategy is a credit spread. A call credit spread consists of 1 short call and 1 long call at a higher strike price. Due to the short call, this strategy takes advantage of the following:

• Time decay (the strategy gains some value just for the passage of time)
• The underlying asset’s price has room to move in
• Therefore, the strategy has a relatively high POP

Furthermore, a credit spread also is a defined risk strategy because the long call option acts as a hedge.

 

As you can see, combining long and short option positions can be an awesome alternative to just selling naked options or buying standalone options. A credit spread is just one of many example strategies that do this.

But note that option strategies also either are overall long or overall short. This usually depends on the option with the strike price closest to the underlying’s price.

Credit spreads are overall short strategies because the strike price of the short call is closest to the underlying asset’s price. Once again, I’ll present this with a short and simple example:

XYZ is trading at $75. Max wants to trade a call credit spread on XYZ. Therefore, he sells an option at the 80 strike price and buys an option at the 85 strike price. The sold option is much closer to XYZ’s trading price ($75). That’s why this strategy is an overall short strategy.

If you would switch around the short and long call on a credit spread, it would become an overall long strategy. But more on specific strategies in the next lesson.

Generally, I recommend trading option strategies over standalone options.

 

Should you Buy or Sell Options:

First of all, this really depends on your trading style and what you want to achieve. If the purpose is to add some protection to your portfolio or to put on some directional bets, then buying options is probably a better choice than selling options. However, short option strategies will be better for other purposes. The high probability aspect of option selling makes selling options very attractive.

Furthermore, a decision between buying and selling options also depends on some factors:

 

• The current state of implied volatility (IV) in an asset can be very important when deciding on what to trade. Like I mentioned earlier, long option strategies profit from an increase in IV and short option strategies profit from a drop in IV. Therefore, it is best to trade short strategies in times of high IV and long strategies in times of low IV. This will create another profit opportunity besides the price moves in the underlying asset. Due to this, it is essential to know if IV currently is high or low. An awesome way of doing this is using IV Rank.

 

• Another deciding factor is your portfolio. If you currently already have a lot of long option positions open, you may consider some short option positions and vice versa. You will learn more about portfolio diversification in a later lesson.

 

• Otherwise, there still are some other factors that could influence a decision between buying and selling options.

 

 

Please let me know if you understood everything in this lesson. If there is anything that you need help with, don’t hesitate to comment! I will respond to every comment as fast as I can. Click HERE to comment!

 

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This Article is part of the Intermediate Option Trading Course. If you are reading the article as a part of the course, you should now be ready to learn how specific option strategies work. To do that, you will have to visit the strategy section. There are many different strategies to learn about in the strategy section. I recommend learning about a few different strategies. The most important ones for this course are Credit Spreads and Iron Condors. But feel free to read more about other strategies as well. After that, you can continue to the next lesson: HERE