Introduction to Trading Approaches
Just like a professional athlete would not approach their sport without a plan for how to perform, Option traders who want to be successful need a game plan. This game plan has three elements: selecting a trading approach, selecting a trading style and selecting the right option strategies. In this part of the Beginner’s Guide to options trading, we’ll consider the first element, the trading approach.
Options give traders powerful tools to seek out trading opportunities in any market condition. The two different types of options, calls and puts, provide traders an opportunity to benefit from either rising or falling stock prices. But there is also an alternative to buying call or put options. An option trader can choose to approach option trading as a seller, rather than a buyer.
Option buyers purchase a chance to either buy a stock or sell it short, but option sellers look for a chance to capture the price of the option itself. This approach is quite different from speculation of price movement and represents its own set of challenges and opportunities. Option traders should learn how both option buying and selling approaches work.
The difference between the two approaches is a difference in probability. It’s true that option buyers can come across big opportunities, but the probabilities built into option pricing formulas actually favor option sellers.
That’s because buyers always face the same two challenges on every trade: a built-in expiration date and time decay. Sellers face a different challenge: the risk that the stock may move strongly in favor of the buyer.
Let’s take a closer look at the pros and cons of these two approaches.
First consider the benefits of being an option buyer: big opportunity and limited risk.
As an option buyer, you get to hunt down big opportunities. You may not always get the timing right on an option trade, but if you do, the opportunity for unusually large returns does exist. The challenge of being a buyer is that option prices are usually set in such a way that buyers have a lower probability of winning their trades than losing them.
The second benefit is that you can clearly define how much you will risk and keep your losses limited to that amount. When you have a losing trade, the amount of money you put into the trade represents the total amount you have at risk.
The benefits of being an option seller are different. Sellers get favorable pricing and probability in comparison to option buyers. But it comes at a cost.
The first benefit of being a seller is that you get to collect time value instead of paying for it.
Since time decay happens every day, option sellers benefit from that daily dynamic. If the stock price does not move strongly in the option buyer’s favor, then time decay ensures that the seller will be more likely to see their position benefit.
The second benefit is that option sellers don’t need to have excellent timing. Options are priced to favor the sellers, because sellers set the price in a way that covers most of their risk. The price of an option reflects what sellers expect to see happen with the stock. If they expect the stock price to move strongly against them, they set the price of the option higher. This market action means sellers are more likely to be successful every day the stock closes without big moves in the buyer’s favor. That is why sellers have a higher frequency of opportunities for good trade setups.
It’s also true that each decision comes with tradeoffs. For example, those who buy options have the potential for a big opportunity, while those who sell options give up that potential in exchange for smaller, more frequent opportunities.
Another tradeoff has to do with how much an option trader must risk. The premium a buyer pays represents their entire risk of the trade. However, sellers take on much more risk in exchange for the premium they collect. That’s because when a trade goes against a seller, the losses aren’t limited to the cost of the option premium collected, but the potential profits are.
A good rule of thumb is that option buyers will experience less frequent opportunities but have correspondingly larger trade setups compared to the risks. By comparison, option sellers will experience more frequent opportunities but take correspondingly larger risks compared to the cost of the trade.
These pros and cons tend to balance out in such a way that neither side has much mathematical advantage over the other. However once a trader has chosen an approach, they also have to select a trading style and option strategies that are likely to work well for them. Both of those elements are discussed in the next parts of the guide.