How Option Selling is much more profitable than Option Buying?

It is a general perception among traders that option buyer has limited risk and option seller always has unlimited risks. In this post, we will analyze some data points for option buyers and sellers.

Option Buyer
An option buyer pays an option premium for buying options on an underlying (stock or commodity). He is the one who is taking insurance on the underlying when things go against his direction.

Option Seller
An option seller gets an option premium for selling the option on an underlying (stock or commodity). He is like an insurance seller who is giving insurance to another party when the underlying moves in the direction of the option buyer.

These were the basic definitions of option buyer and seller. But here we forgot the most important thing which is that options are time-bound contracts. They will expire someday in the future. Therefore even if underlying (stock or commodity) doesn’t move in your direction, the premium will erode.

Below is the chart which explains how Premium erosion takes place

Limitations for Option Buyer

1. Option premium will always decrease as the option moves towards expiry.
   Premium erosion will be very high for OTM (out of the money) option
2. An option buyer is generally clueless when to square off the option. Theoretically, option prices can rise up to any level but in practical scenarios, the gain is only limited as option buyers never know what could be the highest price of the option.
3. Option premium will decrease even if underlying doesn’t move in any direction.

Let us take an example of option on SBI (8 week chart)

SBI is in a continuous downtrend and has been falling for the last 3-4 months. It has given minor spikes in between but the overall trend is bearish.
Neither the rise is linear nor the fall. Therefore in such cases if you want to bet on SBI buy buying a put option is misleading.
As an option buyer (PE) your premium will decrease if fall in stock is not linear. We will take an example of OTM (170PE)

Chart of SBI May 170PE

In the above chart as you can see, if we would be the one who was betting that SBI will fall in Apr, has lost almost most of the premium paid.
As an option buyer, once you have taken a position and you star losing premium, you cannot predict by how much your premium paid will recover.
Here prediction is just like a hope which should come true so that an option buyer can make money.

Now let us examine Daily Return of last 1 year of SBI

As an option buyer, we need to get at least a 4-8% move in underlying if we want to some increase option premium (otherwise need to buy ITM which are very expensive). But as per the data in the graph, most of the returns are scattered in +-3%. Therefore we can say it is very difficult to make money as an option buyer.

Option buying is much more complicated and needed well research then option selling.

A option buyer should

1. Calculate by how much stock will move in a day.
2. Option buying in a high Vix environment could be disastrous.
3. Calculate the entry and exit points by anticipating a stock move in the next 1 week.
4. run on the hope that underlying will move in his predicted direction. (will loose on premium)
5. Should not take a heavy position as, during results or some important corporate announcements by company, options already incorporate high premiums.

I hope this post helped you in improving your knowledge of options. Thanks for reading.