More Profitable: Buying or Selling Puts?
02/03/2014 8:00 am EST
While there are appropriate times for both put-buying and put-selling strategies, because put buyers don’t necessarily have to be correct about market direction, the profit potential is higher for put sellers, says Josip Causic of Online Trading Academy.
I’m going to answer the question in the title of this MoneyShow.com article right now: selling puts is more profitable. In order to support the point that there are more possible opportunities to benefit from selling options rather than buying them, this article will look into the intricacies of option buying and selling.
For simplicity’s sake, this discussion will focus only on puts. Hence, the logical division of this article is two-fold: The first part about a long put, and the second about a short put.
Part One: Put Buying (+p)
Occasionally, I am asked if the idea of buying a put is a good idea, period. That question is so loaded that without the proper context, it cannot be correctly answered.
If a trader is considering buying a put, then the environment should not only be bearish, but also the price action should be doing either one of two things.
Number one, the price action should challenge support but fail to bounce off that support, consequently heading lower. In this first case, the support is clearly broken and the price action is in a freefall; therefore, shorting either by selling short or buying a long put would be the correct strategy.
The only difference between the two (short selling the actual underlying and +p) would be the time component. Options have a finite lifespan.
The second ideal environment for buying a long put would be when price is at resistance, specifically after price has failed to break above it, giving up the upward push and falling lower.
In either of these two cases (at resistance or at support), the price action can still do three things: Go up, go down, or simply chop around in a sideways motion. Hence, if a buyer of options purchases a put, what would be his/her probability of winning?
There are three possible outcomes, yet the desired outcome is only one: that the underlying price would drop. When one (the favorable outcome) is divided by three possibilities, there is only a 33.3% chance of winning, while there is a 66.6% chance of not winning.
To recap, put buying (+p) is done with the intention of seeing the put premium go up in value, which is only possible if the stock goes down in value. The put buyer’s goal is to see the stock drop. Ideally, the implied volatility should be low when purchasing the put so that the option premium is not overpriced.
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Part Two: Put Selling (-p)
But contrary to buying, put selling (-p) is done when the bias is bullish, or at least moderately bullish. This means that premium is received by the put seller, and whether the price action takes off wildly or just simply grinds up, the premium received is just the same. The only undesirable outcome is if the put was sold and the underlying drops.
Figure 1 below shows the different outcomes possible for the underlying, comparing +p to –p. Notice in the table that a different color font was used to emphasize the point that the +p is a bearish strategy (red font), and the –p is a bullish (green font) strategy.
Due to the fact that there is built-in protection in put selling, which equals the amount of the premium received, the whole mathematical calculation for the probability of whether or not the market action will bring a good outcome changes.
If the underlying goes down, and we are holding on to a sold put, whether we lose or not will depend on exactly how much the underlying drops. When it comes to selling options, the up, down, and sideways world is not specific enough. There are two extra levels needed to judge the outcome: The market going up a lot and going down a lot.
When these two additional outcome possibilities are entered into the discussion, then we can see the market in full color. Figure 2 emphasizes this point for a –p.
To recap, put selling (-p) is done when not much is expected from the underlying. Ideally, the implied volatility should be high. The put seller’s goal is to see the option expire worthless. A put seller gets paid up front and as long the stock goes up or stays at least flat, and maybe even goes down a little, the premium is kept by the seller; basically, almost as money for nothing.
In conclusion, this article has pointed out that a trader’s mindset is different when selling versus buying an option. With a bought put, we expect a move down and are expecting it now, whereas with a sold put, not much in terms of price action needs to happen; the underlying can go up, up a lot, sideways, or even down a BIT before we have any concern.
As one of my trading buddies would say: "When you sell a put, you do not live in the world of ‘have to be correct to make money.’" Which one (buying a put or selling a put) a trader chooses will always be in the eye of the ultimate observer. There is a right time for both actions.
By Josip Causic, Instructor, Online Trading Academy