Why Selling is the Key to Success?
If there is one way that the most people lose money, it lies in buying options whether they are call or put options.
We have reproduced in part an article in part published in Futures magazine March 2003 Option Sellers vs.
buyers: Who wins? By John F.
Summa.
Article reads as follows: Option traders rarely take into account a little known underlying fact about these derivative markets as most of the options expire at Out-Of-The-Money.
A study analyzing three years of data compiled by the Chicago Mercantile Exchange (CME) confirms it.
That means buyers lose on most option trades.
Given this option market reality, serious option traders should consider developing a net option selling (writing) approach to take advantage of this tendency.
Three key patterns emerge from the study of CME data; 1.
On average, three out of every four options held to expiration end up worthless.
2.
The share of puts and calls that expired worthless is influenced by the primary trend of the underlying market.
3.
Option sellers still come out ahead even when the seller is going against the trend.
Based on a CME study of expiring and exercised options covering a period of three years (1997, 1998, 1999), an average of 76.
5% of all options held to expiration in five markets expired worthless (Out-Of-The-Money).
The number remained consistent for the three year period.
The actual numbers for five markets show more than 20 million expired (worthless) options and a little more than 6 million exercised (in-the money) options.
Future options that are In-The-Money at expiration are exercised automatically.
Therefore, we can derive total expired worthless options by subtracting those exercised from total options held to expiration.
A closer look at the data reveals certain patterns, such as how a trend bias in the underlying affects the share of call options vs.
put options expiring worthless.
Clearly, however, the overall pattern in that most options expired worthless.
As a whole, S&P 500 put options recorded the highest percentage with 82.
6% expiring Out-Of-The-Money or worthless.
The percentage was above the average for the whole study-76.
5% of all CME Futures options expired worthless- and due to the stock index options on futures (NASDAQ 100 and S&P 500) having very large number of put options expiring worthless-more than 90%.
This bias in favour of put sellers can be attributed to the strong bullish bias of the stock indexes during the period although there were some sharp but short-lived market declines.
Data for 2001-03, however, would no doubt show a shift toward more calls expiring worthless, reflecting the change in a primary bear, market trend since 2000.
Here are some of the main reasons in favour of options selling vs.
buying: 1.
Going against the trend: As is obvious from the above article that even if you end up going against the trend, the odds are in your favour for Out-Of-The-Money options expiring worthless, while it is absolutely opposite for the option buyers.
2.
Not controlled by greed: When you buy options, you may be controlled by the greed as it may be difficult to determine as to when the trend may reverse itself.
You may end up selling the option either too early or too late.
This may not be the case when you sell put options as in the worst case scenario you may end up owing the stock at a low price that you may have intended to buy at the first place.
3.
No Stop Losses: When you buy options, you may put stop losses below or above a certain price.
You may have done it based on a technical or fundamental analysis.
How many times did it happen that the market will go down or go up to your stop loss point, take you out of the market and then reversed the direction? You may not have to place a stop loss order when you sell puts as in the worst case you will end up owning the stock at a price that you intended to buy at.
4.
Time in your favour: This is one of biggest advantage of selling options instead of buying it.
It has been discussed in the previous chapters that every option has two values.
One is intrinsic value and the other being the time value.
Even if the stock does not move against the trend, time value of the options will keep on eroding every day.
Thus option being of lesser value on every coming day while the opposite is true when you sell options.
Seller is a gainer every day even if the stock does not move at all.
5.
Earn interest on other's money; When you sell options, it adds up money in your account.
Even though you may not be able to withdraw it, you earn interest on the money every day until the day of expiration.
The opposite is true when you buy options.
In this regard, you have to be very careful in selecting the right brokerage company.
The majority of the brokerage companies don't pay interest on the money which is accumulated by selling options.
Down side of selling Options: 1.
Unlimited Risk: When you buy the options, your maximum loss is limited to the amount of the money that you paid to buy those options while the opposite is true for the seller of the options.
Seller is exposed to buying back the option at a much higher price.
However, there are ways to control this unlimited part of the risk by using several strategies which have been discussed in the chapters that follow.
2.
Limited Profit: Seller of an option definitely has this disadvantage.
Seller cannot possibly make more than the amount that he sold the option for.
We have reproduced in part an article in part published in Futures magazine March 2003 Option Sellers vs.
buyers: Who wins? By John F.
Summa.
Article reads as follows: Option traders rarely take into account a little known underlying fact about these derivative markets as most of the options expire at Out-Of-The-Money.
A study analyzing three years of data compiled by the Chicago Mercantile Exchange (CME) confirms it.
That means buyers lose on most option trades.
Given this option market reality, serious option traders should consider developing a net option selling (writing) approach to take advantage of this tendency.
Three key patterns emerge from the study of CME data; 1.
On average, three out of every four options held to expiration end up worthless.
2.
The share of puts and calls that expired worthless is influenced by the primary trend of the underlying market.
3.
Option sellers still come out ahead even when the seller is going against the trend.
Based on a CME study of expiring and exercised options covering a period of three years (1997, 1998, 1999), an average of 76.
5% of all options held to expiration in five markets expired worthless (Out-Of-The-Money).
The number remained consistent for the three year period.
The actual numbers for five markets show more than 20 million expired (worthless) options and a little more than 6 million exercised (in-the money) options.
Future options that are In-The-Money at expiration are exercised automatically.
Therefore, we can derive total expired worthless options by subtracting those exercised from total options held to expiration.
A closer look at the data reveals certain patterns, such as how a trend bias in the underlying affects the share of call options vs.
put options expiring worthless.
Clearly, however, the overall pattern in that most options expired worthless.
As a whole, S&P 500 put options recorded the highest percentage with 82.
6% expiring Out-Of-The-Money or worthless.
The percentage was above the average for the whole study-76.
5% of all CME Futures options expired worthless- and due to the stock index options on futures (NASDAQ 100 and S&P 500) having very large number of put options expiring worthless-more than 90%.
This bias in favour of put sellers can be attributed to the strong bullish bias of the stock indexes during the period although there were some sharp but short-lived market declines.
Data for 2001-03, however, would no doubt show a shift toward more calls expiring worthless, reflecting the change in a primary bear, market trend since 2000.
Here are some of the main reasons in favour of options selling vs.
buying: 1.
Going against the trend: As is obvious from the above article that even if you end up going against the trend, the odds are in your favour for Out-Of-The-Money options expiring worthless, while it is absolutely opposite for the option buyers.
2.
Not controlled by greed: When you buy options, you may be controlled by the greed as it may be difficult to determine as to when the trend may reverse itself.
You may end up selling the option either too early or too late.
This may not be the case when you sell put options as in the worst case scenario you may end up owing the stock at a low price that you may have intended to buy at the first place.
3.
No Stop Losses: When you buy options, you may put stop losses below or above a certain price.
You may have done it based on a technical or fundamental analysis.
How many times did it happen that the market will go down or go up to your stop loss point, take you out of the market and then reversed the direction? You may not have to place a stop loss order when you sell puts as in the worst case you will end up owning the stock at a price that you intended to buy at.
4.
Time in your favour: This is one of biggest advantage of selling options instead of buying it.
It has been discussed in the previous chapters that every option has two values.
One is intrinsic value and the other being the time value.
Even if the stock does not move against the trend, time value of the options will keep on eroding every day.
Thus option being of lesser value on every coming day while the opposite is true when you sell options.
Seller is a gainer every day even if the stock does not move at all.
5.
Earn interest on other's money; When you sell options, it adds up money in your account.
Even though you may not be able to withdraw it, you earn interest on the money every day until the day of expiration.
The opposite is true when you buy options.
In this regard, you have to be very careful in selecting the right brokerage company.
The majority of the brokerage companies don't pay interest on the money which is accumulated by selling options.
Down side of selling Options: 1.
Unlimited Risk: When you buy the options, your maximum loss is limited to the amount of the money that you paid to buy those options while the opposite is true for the seller of the options.
Seller is exposed to buying back the option at a much higher price.
However, there are ways to control this unlimited part of the risk by using several strategies which have been discussed in the chapters that follow.
2.
Limited Profit: Seller of an option definitely has this disadvantage.
Seller cannot possibly make more than the amount that he sold the option for.
Source...