Should I buy or sell options?

If you’re considering opening an options position and you’re trying to decide whether to buy or sell options, read this guide to help you choose. 

buy or sell options

How to Decide Whether to Buy or Sell Options

January 14, 2023 | by OptionDirection Team
Introduction

If you’re trying to choose whether to be an options buyer or seller, even though there is no cut-and-dried formula, you should consider factors such as: 1) the volatility of the stock/ETF, 2) your expectation of what kind of move will happen in the stock, and 3) your return-on-investment (ROI) goals and risk-tolerance for the trade. In this article, we’ll cover these key concepts in order to help you decide whether it’s more optimal to buy or sell options. Towards the end, we’ll also list some basic options strategies based on the volatility environment and your expectations for the stock (bullish, bearish, or neutral). We’ll also provide some ideas to mitigate risk as an options buyer or seller by implementing vertical spreads.

When Do We Buy or Sell Options?

Here’s a quick rundown of what a buyer of an option wants vs what a seller of an option wants.

As you are aware, when you buy an option (i.e. a call or a put), you want the option to go up in value. The way an option goes up in value is if the underlying stock moves in a particular direction in a given timeframe. So, if you are betting on a big movement, then it’s better to be a buyer of an option.

Conversely, when you sell an option, (i.e. a call or a put), you want the option to go down in value. The way an option goes down in value is if the underlying stock does not move in a particular direction in a given timeframe. Therefore, if you are betting on a big movement to not happen, then it’s better to be a seller of an option.

What is the Volatility of the Stock?

A key variable to consider when you’re trying to decide whether to buy or sell an option is implied volatility. A stock’s volatility is already embedded into an option’s price since when volatility increases, it causes an option to rise in value and when volatility decreases, it causes an option to fall in value.

Assuming that you’re expecting volatility to behave in a mean-reverting way during the lifetime of your option, in times of low volatility, it is generally more beneficial to buy options since when volatility goes back higher, your options will increase in value. Conversely, in times of high volatility, it is generally more beneficial to sell options since when volatility goes back lower, your options will decrease in value.

Some important metrics to look at are IV rank and IV percentile. When these numbers are high (50 or higher), it indicates that the stock is more volatile and might be a good candidate for selling options, whereas low numbers (lower than 50) indicate that the stock is less volatile and might be a good candidate for buying options.

Are You Expecting a Big or Small Move?

Based upon the current volatility, the option chain will tell you the expected move of a stock in either direction for that expiration cycle. When volatility is low, the market is expecting a relatively small move in the stock and so its options are generally priced lower. In this environment, if you are predicting a large move in the stock, then it’s better to be a buyer of options. Options will be relatively cheap at this time, and you’re hoping that they will increase in value in order to profit. (This doesn’t mean that you can’t do well as an options seller, but if volatility rises, it will not help your position.)

By the same token, when volatility is high, the market is expecting a relatively large move in the stock and so its options are generally priced higher. In this environment, if you are predicting only a small move in the stock, then it’s better to be a seller of options. Options will be richly priced and ripe for selling at this time, and you’re hoping that they will decrease in value in order to profit. (This doesn’t mean that you can’t do well as an options buyer, but if volatility falls, it will not help your position.)

What Are Your ROI Goals and Risk-Tolerance?

When you are a buyer of an option, you have a substantial profit potential and the maximum loss is limited to the amount that you paid for the option. For example, a call option holder has an unlimited profit potential since the stock can theoretically go up to infinity. Similarly, a put option holder can make a large amount of money if the stock plunges and potentially goes to zero.

On the other hand, as a seller of an option, your potential profit is limited to the credit that you collected when you sold the option, although your maximum loss can be substantial. For example, a call option seller has an unlimited loss potential since the stock can theoretically go up to infinity. Similarly, a put option seller can lose a great deal of money if the stock plunges and potentially goes to zero.

After reading this, if you’re wondering why anyone would ever sell options, read this article where we go over the benefits of selling out-of-the-money (OTM) options in order to improve our probability of profit and make time decay work in our favor if the stock fails to reach our OTM strike price. Selling options also gives us more flexibility to adjust a position if our original assumption turns out to be wrong.

It’s important to note that both buying and selling options involve significant risk. The risk for an options buyer if the stock doesn’t cooperate is that they lose the full options premium due to time decay. The risk for an options seller is that the stock goes against them and they lose a large sum of money.

To limit this risk (for buyers and sellers), a common strategy is to buy or sell vertical spreads instead. This involves buying (or selling) an option at one strike and selling (or buying) an option at a farther away strike to limit the losses in case the stock turns against them.

Even though vertical spreads limit your potential gains, they also limit your potential losses. Additionally, spreads give you the ability to implement smaller positions for much cheaper. To learn about the different types of vertical spreads and other strategies, take a look at our options strategies page.

Choose a Strategy Based on Conditions

The below table lists some basic strategies that you could execute based on conditions and your expectations. Note that this table is intended to be a general guideline and is not a formula for success. For example, just because the table indicates that you should buy vertical spreads in times of low volatility, it doesn’t mean that you won’t do well selling vertical spreads in that environment.

 

Low-volatility environment

High-volatility environment

You are bullish

Buy a call, buy a call vertical spread

Sell a put, sell a put vertical spread

You are bearish

Buy a put, buy a put vertical spread

Sell a call, sell a call vertical spread

You are neutral

Buy a strangle, buy an iron condor

Sell a strangle, sell an iron condor

Note that buying a strangle means that you’re buying both a call and a put; selling a strangle means that you’re selling both a call and a put. If you’re buying an iron condor, it means that you’re buying both a call vertical spread and a put vertical spread; if you’re selling an iron condor, it means that you’re selling both a call vertical spread and a put vertical spread.

Conclusion

It’s always tricky, even for experienced options traders, to determine whether to buy or sell options positions. But following the simple guidelines discussed in this article will help you to improve your chances of success. When you sign up with OptionDirection, you will receive our researched trade ideas, some of which are for selling options and some of which are for buying options. Sign up now to implement our trade ideas, generate exceptional returns, and build wealth with options.

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