Before I started teaching myself option selling strategies, I already bought several calls and puts to bet on a huge move in the share price of the underlying security, but in most cases my options expired worthless and time was eroding the option value. I wasn't informed about what drove my investment failure when purchasing options. So what's the reason the odds are tremendously stacked against short-term option buyers? In other words, why do so few people sell options regularly and why do speculators continue to fall into the trap of losing their money most of time? Let's deal with these questions in this venue.
It is estimated that anywhere from 75 to 80 percent of all options held through expiration will indeed expire worthless. Additionally, it is estimated that only 10 percent or less of all options will ever be exercised. This being the case, why aren’t more investors taking advantage of this phenomenal statistic? Most traders - I have to admit that just 1% makes it to the top - fail to generate consistently positive returns because of trying to pick the top or bottom at the right moment. I'd like to call the mechanism of option selling as follows: option selling does not involves timing the market to make profits, it's about understanding where the markets won't go. In contrast to popular belief, people love buying options courtesy of unlimited upside and limited downside. The only thing you could lose assuming the movement in the share price you did anticipate won't come true is the premium paid. As a result, most investors have an unjustified and rosy opinion about the risk/reward profile of option buying. Stated differently, the profit-and-loss graph for option selling looks way too deceiving as it relates to the higher probability of trading succes. At first glance, option selling should definitely be thrown away because of unlimited downside and limited upside...
But aren't we smart enough to figure out several scenarios in order to decide for ourselves which strategy fits best into our overall investment methodology?
Let me give you an easy-to-grap example using puts (you can do the same for the calls):
There's a stock trading at $100 and we sell an out-of-the-money put with a strike price of $96 thereby receiving a cash premium of $3.5, or to put another way, we are willing to purchase the stock over the next one month for $96.
Since we sell an option to the option buyer, we give this anonymous person (because everything is done online with the click of the computer) the right to sell his/her shares to us AT ANY TIME over the next one month.
If the price goes down dramatically below $96, the option buyer has managed to leverage his relatively small investment (premium paid only) whereas we would face a huge, nearly 'unlimited' loss unless we take some action called exit strategy execution.
What's the difference between our final situation and the buyer's one? Well, as option sellers because of elapsing time value erosion, time is on our side. Also, we don't have to time the market since as long as the stock remains above $96, which means we fully capture that $3.5 cash premium. If the stock would drop below $92.5 we start to lose money.That's precisely a level which the option buyer keeps a keen eye on. As long as the price remains above that point, the option buyer's 'bet' is still underwater. In other words, the more likely an event will take place (in this case a drop in share value from $100 to $92.5 over a one-month period) the higher the premium the option seller receives, but the lower his/her rate of succes and therefore positive return will be. That's the trade-off. In short, if you sell the $98 put, your breakeven is $92.5, while time is on your side. As long as the price remains above that level, you won't have lost money no matter if you was wrong about the specific price direction. In return, we have a maximum profit (cash premium); the option buyer only generates a substantial profit if volatility spikes or if the price drops below $92.5. As long as the price remains above that level and the option value is elapsing rapidly, he will theoretically lose his ENTIRE investment (premium paid) little by little by the end of the contract period. It's a rather false feeling of safety because we will never lose more than the premium invested, whereas a huge stock investment results in a lower return on investment while there's a lot of capital being at risk of a potential default. The wider the price range in which your option selling trade generates positive returns, the higher the probability of investment success even without exactly timing the markets! Time is on our side and we know that it's way too hard to predict short-term share prices so we sell options to someone who thinks he can surely time the markets driven by greed, which will very likely lead to substantial accumulating losses over time.