Buy Options or Sell Them?

Should you buy or sell options?

What do you think?

It depends.

If you listen to the folklore, 80 – 90% of options expire worthless. That indicates that it is more profitable to sell options.

On the other hand, like a lottery ticket, an option can pay off big. So you should buy.

What about the risks?

If you buy an option, you can lose the premium you pay so the risk is limited.

If you sell, your risk is unlimited if you sell a call and the stock goes to the moon.

Event Trades

Like the event trade discussed in the last two posts, it depends on what volatility will do and if you expect a spike in price. The event we looked at this week was the Treasury Secretary’s speech on the fiscal stimulus plan. The financial stocks are so volatile now that you can expect large spikes in price often. So we bought.

Another common event is quarterly earnings. As the earnings date approaches there is an increase in uncertainty about what the earnings will be. Implied volatility may increase because there is a chance for a big price move on earnings. That would be dangerous to sell. Earnings are of ten announced after the market closes or before it opens.

If you are short the option and the price of the stock moves overnight against you, the only thing that you can do is sell or buy stock in the after hours market which is illiquid with larger bid ask spreads, or wait until the market opens to get out of your position.

Volatility Trades

As a first pass, compare historical volatility to implied volatility. If implied volatility is much higher than historical volatility, that is a candidate for sale. If implied is much lower than historical, you might want to buy.

Next look at how volatility varies through time. Plot it. Is the historical volatility low now or high? What is the implied volatility of the options. Answering these questions will help you formulate good trades.