Understanding Options Selling & Options Trading

Have you ever wondered how Warren Buffett became the greatest investor of all time? Besides being a strong advocate for Value Investing - identifying undervalued stocks below their intrinsic value, Buffett is also known to practice Option Selling - a way to collect premiums and generate massive amounts of wealth.

More often than not, Options Selling and Options Trading have been used interchangeably whilst they could totally mean different spectrums of things. To start off, let's explore what are Options!

Essentially, Options are financial contract that gives the buyer the obligation the right to buy or sell an underlying asset at a specific price within a predetermined time. There are mainly 2 different types of Options namely Put Options and Call Options. A Put Option is a contract that gives the buyer the right to SELL 100 shares at a Strike Price on/before an Expiration Date. Similarly, the Call Option is a contract that gives the buyer the right to BUY 100 shares at Strike Price on/before an Expiration Date. Furthermore in Options, the term "Premium" refers to the upfront fee paid by the Options Trader that gives them the right to buy or sell the stock before the contract expires. In addition, Options premiums are assessed by share, and since the Options contract equals 100 shares, the Option premium of $0.5 per share multiplied by 100 shares will be $50.

Example of PUT Options: ABC 100 Dec 23 55 PUT @ 0.23

ABC : Ticker Symbol of the Stock

100 : Contract of 100 Shares

Dec 23 : Options Expiration Date ( Typically 3rd Friday of the month)

55 : Agreed Strike Price

PUT : Put Options contract

0.23 : Premium for each share; Total Premium: $0.23 x 100 = $23

Example of CALL Options: AAPL 100 Dec 23 60 CALL @ 0.50

AAPL : Ticker Symbol of the Stock

100 : Contract of 100 Shares

Dec 23 : Options Expiration Date ( Typically 3rd Friday of the month)

60 : Agreed Strike Price

CALL : CALL Options contract

0.50 : Premium for each share; Total Premium: $0.50 x 100 = $50

Summary of Options Selling :

Summary of Options Trading :

As investors or value investors, our primary role is to identify good and undervalued companies and purchase them below their intrinsic values. While many may point out the "underlying loss" when the Options sellers have their options exercised especially the selling of Put options, it is important to note that the Options seller is not only receiving the premiums but also the ability to purchase the stock at the agreed upon strike price. In short, the Options seller is purchasing the contract at a discounted price! In the event that the Options seller's contract expires, he or she gets to keep the premium which is often seen as an added revenue to their investment portfolio. As such in my personal opinion, Options Selling is seen as a win-win approach!

On the other hand, the Options Trader is playing a more speculative game where it speculates whether the stock is bullish or bearish. Truth is, can we actually determine the stock price movement, especially in the short run? Perhaps an experienced Options trader can see the "blindspot" that a novice trader won't. But nonetheless, speculation is something ambiguous and may result in large financial losses if not taught properly.

Factors that work against Options Traders :

1. Transaction Costs

Options Trading like any other form of trading requires frequent entry and exit in the financial market which often results in a heavy amount of commission and fees. In return, this would "eat up" a significant amount of profits from the trade.

2. Time Decay

Options as a financial derivative have a limited timespan which will have their value erode when the contract approaches its expiry date. As such, if the Options trader is unable to sell the options before the expiration date, it will mean that he or she will lose 100% of the upfront capital - the premium paid.

3. No Dividends

Unlike Stocks, Options are just a piece of contract that will expire worthless upon its expiration date. With no stake in the company's share, Options traders will not receive dividends from the Options trade transacted as they are buying the options contract and not the stock itself.

4. Bid-Ask Spread

The Bid-Ask Spread refers to the difference between the highest price the Options trader is willing to buy (Bid) for an Options contract and the lowest price the Options Seller is willing to sell (Ask) for that particular contract. For instance, if the bid price for an Options contract is $2.20 while the ask price is $2.50. In the event that the Options buyer decides to buy and sell at the same time, they would incur a loss of $0.30 per contract without even factoring in the costs of commissions.

Concluding Remarks :

In general, Options sellers Write the Option, Sell the Options Contract, and Collect Premiums. On the contrary, Options traders Buy the Options, Sell the Options Contract and Make the difference.

For one to fully understand the concept of Options Selling and Options Trading, it is best to educate ourselves with the relevant knowledge and materials. For instance, if one is keen in Options Trading, he or she would need to be well versed with a variety of strategies like "Iron Condor", "Straddle", and "Butterfly Spread" used for different market conditions for profit optimisation.

To put things into practice, one can always create a demo account, and get the hang of it before putting their hard-earned money into the actual trading account. By doing so, it will give them the necessary confidence without risking significant financial losses. Lastly, like what Warren Buffett always preaches, rule#1: Never lose money & rule #2: Never forget rule no#1. Always remember to exercise our due diligence before any form of investment or trade.

Kudos to you for reading till here! Feel free to comment down below your perspective and let's all learn from one another! :)