Buying Options or Selling Options

07/13/2017 2:53 am EST

Focus: STOCKS

Juan Sarmiento

Independent Trader, putcallgenie.com

Your job is to time your entry by waiting for a correction, opposite to the trend, and enter your trade when the stock price shows signs of resuming its trend, says Juan I. Sarmiento, DVM, Ph.D., President and Founder of PutCallGenie.

Ten years ago, I was asked if selling options was really the right approach because most professional traders will tell you, that is how they trade. I did not know the answer at the time. I had been mostly buying options as a substitute to stock buying, during the .combubble. The question stayed with me and I think I finally have the answer, and it is not a short one (no pun intended).

Option selling is based on probabilities. If you sell a put when you are bullish on a stock, you are most likely to make a profit of some sort. Your probability of making at least $0.01 is about 60%, depending on the option’s strike price relative to the current market price, the option’s time to expiration and its implied volatility.

If you are a professional trader, you can afford to have dozens of trades at a time, and just like Mendel’s pea counting, the more the number of occurrences, the closer you will get to your estimated probability (60%).

The goal is that, at the end of the year, you will have a good profit, regardless of the ups and downs of the market, or your ability to pick the right direction.

For the rest of us (retail traders), it is not so simple.

Even if you are fortunate enough to have a good amount of capital and are financially independent, you may not want to have to work at trading as if it was your full-time job. Some of us may like our non-trading work or job and feel that we make a contribution to society with our profession or talent.

Personally, I contribute to the biotechnology industry as a pathologist. Yet trading is one of my passions. I have been trading options since the early 1990s. Since my beginnings, I have always preferred to be net long options, although I do take advantage of the decaying nature of options. In future articles, I will reveal my favorite options trading approaches, but for now, I'd like to focus on the basics.

As a retail trader, I started as a stock buyer and converted to options because of the characteristic leverage of options after I discover a certain “set-up,” that is, a typical price chart formation that often resulted in a strong rally.

Yes, back in the 90s when the internet was in its infancy, I selected a watch list of 30 stocks in intermediate bullish trends. And then I patiently waited for a pullback corresponding to the Fibonacci ratios (38.2%, 50% or 61.8%) of the previous rally, aided by an oscillator to find the buying signal to time my options trade.

Without a doubt, this is a system meant for bullish markets, which is all I knew until 2001. This strategy is illustrative of what a retail options buyer might do that the professional will not. The professional wants to trade all the time, and the options buyer waits for the right opportunity and might enter one trade a week or less.

So now I believe that there is no inherent advantage of sellers over buyers, it is just a matter of honing on a set of skills necessary for success. When it comes to options selling vs. buying, you are trying to find your own balance between risk, reward, and the probability of profit.

If you buy an option, your risk is low, your reward potential is large, but your probability is low, as in a lottery ticket with high rewards in a few trades.

If you sell an option, your risk is high, your reward is limited, but your probability is high, which will make you a frequent winner with the occasional, large losing trade. For the options buyer, the probability may increase with your pattern recognition abilities, even if the probability, as calculated by options pricing theory, is low.

For the option seller, it is a numbers game: you want to make as many trades as possible because the probabilities are on your side. However, selling naked options may not be suitable for most of us, so trading spreads with at least an equal number of long and short options may be a more reasonable approach.

Spreads have their own complications and a different set of skills is required, one of which is patience as time will work on your side. But, you will be disappointed to find out that a strong move in your direction may not necessarily translate into large and/or immediate profits because you own a short that will cap your profits and its value only erode close to expiration.

You can profit by buying a simple call or put if you time your trade perfectly, and this is a skill that takes time and effort to develop. In future articles, I will develop this idea. Briefly, a watch list of 30 or more stocks may be classified as bullish or bearish based on their intermediate trend.

Your job is to time your entry by waiting for a correction, opposite to the trend, and enter your trade when the stock price shows signs of resuming its trend.

This is not easy to do, but with some skill may prove to be widely profitable.

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