When to Trade by Selling Options vs. Trade by Buying Options
Options offer you flexibility when trading. You can either buy or sell options (or a combination of both for that matter), this allows you to have strategies for stocks that are moving up or stocks that are moving down. Options even have strategies that make money when the stock doesn’t move at all. Knowing the best strategy to use can mean the difference between a profitable trade and a losing trade. Regardless of how the market is moving, you can select an options trading strategy for your favorite Stock, Index, Futures, or ETF either by buying, or selling an option contract to open the trade. There are some distinct advantages for the options trader that can be had by selecting the appropriate options trading strategy. In this article I will discuss my favorite strategies and how to use each depending if the stock you want to trade is moving up down or sideways.
Increased Implied Volatility Favors Selling Options
Implied Volatility is a measure of the fluctuation of price in an underlying instrument like a stock. As an options trader, the implied volatility will affect the price of an option. Increased implied volatility will increase the price of the option. Each Stock, Index or ETF will have it’s own range of implied volatility. Because of this, to determine high or low volatility we must look at the historical implied volatility of each stock compared to its self. Charting the historical implied volatility of a stock will show you if the current volatility is high or low based on the stock’s history. Implied volatility rank is one measure that gives the trader an indication of how relatively high or low the current implied volatility is. An IV rank of 90% means that the current IV is high while a rank of 10% would mean that it is low. 50% would be average. Options prices reflect how a stock is priced compared to it’s self, so a stock with an implied volatility of 8% and IV rank of 90% would be a candidate to sell a put or call because the premium, or credit received would be high. Similarly a stock with an implied volatility of 30% and an IV rank of 10% would not be a good candidate to sell since the options prices would reflect the historically low IV. You can easily monitor implied volatility on your brokerage platform or charting software. As you gather evidence from the charts and the options chain in order to enter a trade, you might think that a stock with high IV and IV rank is going to have a big move and should be bought to capitalize on that potential high volatility. Sure, you are probably thinking that a big move would favor the options buyer, because after all, more volatility usually means big swings, but this isn’t always the case. This higher implied volatility will have increased the options price meaning that the market is expecting a big move and that the stock will have to see an even bigger move in order to profit from the trade. In other words the market has priced in the higher volatility and is expecting the same big move that you are. This is the reason that most options buyers have trouble consistently profiting from buying puts and buying calls. Most times the moves have already been priced in to the cost of the option and even though the stock moves up or down as expected, the move is not large enough to make the trade profitable.
Buying options with high implied volatility prior to earnings
Increased Implied Volatility is a classic indicator of a big move in stocks. This behavior is most pronounced around earnings announcements. It makes sense since earnings announcements typically move the price of a stock more than the average daily move. This is another scenario where traders fall in to the trap of buying puts or buying calls trying to make large profits after the announcements. Most times these traders will observe that the price of the option they have bought decreases after the announcement, and they are left wondering why the big move in the stock didn’t end up being more profitable. Theoretically, a news event like earnings can bring opportunity for a stock move beyond what is expected by the market. However, the reality is not as consistent as you might expect. Increased implied volatility will mean higher amounts of premium that will need to be paid to buy the put or the call option, in order to account for the higher implied volatility of the upcoming event. Looking at Implied Volatility rank can be a clue to how much premium may be embedded in the cost of an option. You will notice the cost to buy an option will be much higher because of the anticipated move. So, this begs the question, if the cost to buy the option is higher, is the higher price worth it prior to earnings?
Let’s take a look
An options buyer will often end up over paying for an option only to see the premium decay from their trade and ultimately, the profit from buying the option fades away.
Stocks Stuck in a Range Favors Selling Options
Anytime a stock is stuck in a range, I will usually try to sell the option. I want to take advantage of the rangebound price action to my advantage. I will look at selling an out of the money put or call. Selling the option means that I want price to have a small move in to expiry. For example if I sell a put option, I want price to stay flat or move up before expiry. If I sell a call option, I want price to stay flat or move down before expiry. When I sell an option I receive money in my brokerage account, I get to keep that money if at expiration price has not moved through my strike. Stocks that are trading in a range with strong levels of support and resistance are great for selling options. As price moves sideways you are able to profit on the option as the premium in the option will slowly disappear. Rather than trying to guess when a stock will break out of a range, why not sell the option each week until it decides to make its move.
Take a look at this example in CMG:
CMG has been trading in a range for more than one month. This means that you have had an opportunity to trade by selling options successfully outside of this range. Had you traded by selling options below the 470 strike you would have had winning trades each week last month. Rather than trying to determine whether the stock price would sell off, you could have traded the range based on its historical pattern.
Trending Stocks Favor Buying Options
When a stock has been moving in a trend which is established from the daily and weekly chart, I like to buy the option. Generally, if the stock has momentum, the change in price will more than offset the higher implied volatility and added cost you have had to pay to buy the option. Stocks that in a good range either moving up or down are the stocks that I like to use to buy put options and call options. The fast, larger than normal, daily moves in price will allow for the price of the option to increase overcoming the daily time value decay. The momentum in price typically also creates a situation where implied volatility is also increasing, further helping the price of the option increase.
Take a look at this example in MCD McDonalds:
MCD - McDonalds may have slightly higher than average implied volatility because we have been seeing new highs in the stock, but this strong trend indicates that a strategy of buying the call option may be favorable. This daily chart proves that momentum remains as we continue to see mostly higher highs, especially between May and June. Without an indication that this stock is beginning to level off, it looks like an example of using a strategy of buying rather than selling options might be appropriate. Any stock with continued momentum in a strong trend from a daily chart is an option I want to buy rather than sell in the current market conditions.
Out of the Money Strategies Favor Selling Options
The value of the trade strategy that you like to trade most can also impact your decision to buy or sell. If you prefer to trade out, at, or in the money, your decision to sell or buy an option will impact the success of the trade. Even though it may seem appealing to buy options that are out of the money because the cost is low, the probability of success of the trade is less likely. When you by an out of the money option, you are essentially buying an option that is made up of mostly premium and little or no intrinsic value. If the price of the stock has a large move in your favor, then you can do well in the trade, however if the stock moves moderately in your favor, the price of the stock might never move above the strike price of the call option you bought, or below the strike of the put option you bought, leaving your option to expire worthless and a loss on the trade. A lower delta usually means that the price of the option is less likely to have value by the time it expires, thus less likely for an options trader who bought it to end up in a winning trade. If more often than not the put or call option you bought ends up expiring worthless, then looking at the trade from the option seller’s perspective might be beneficial. In order to shift the odds in your favor, you can simply change the way you trade the same strike. Rather than focusing on buying the option, you might consider selling the option. Credit spreads are options trades where you sell a call and buy a call with the same expiry and higher strike or sell a put and buy a put with the same expiry and lower strike. An example would be selling the $140 put in AAPL and buying the $135 put in AAPL with the same expiry dates. The benefit of buying the option as back up is that your losses are limited, unlike selling puts and calls with no back up which can expose a trader to very large losses if the stock moves against them.
Here is a trade example to help you determine if it is better to buy vs. sell an option out of the money:
Say you buy an option out of the money with a delta of .15. A trader who gets this trade right can make a lot of money because the cost to buy an option with a delta 15 will usually be low. The hope is that this option will increase in value substantially, however the chances of success also are low. This trade means by buying the option you will have approximately a 15% chance of the option expiring in the money by $0.01, or 85% of price not moving above the strike you bought. This is fairly low probability, but most traders will place these types of trades. Let’s see how we can increase our chances of success.
If you take a look at the previous example, if the buyer has a 15% chance of success, the seller will have a 85% chance of success. Selling options can if risk is managed, place the odds of success in your favor. By selling a credit spread at the same level instead of buying it, that previous 15% chance of success that worked against you in scenario #1 is now an 85% probability in your favor. By selling the option you are collecting premium and taking the assumption that the option will not have value by the time it expires. You essentially are trading the probability or delta.
Selling vs buying options can be a big influence in determining whether you will be in a winning trade versus a losing trade. Using these measures above will help your trade set ups and can increase the odds of success of yours trades. Options have the flexibility of many strategies to trade. Being a buyer or seller has tremendous influence on your odds of success. Understanding when it is better to buy or sell options can help improve your chances of having a successful trade.
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