Selling Options Short versus Buying Options

Selling options short is one of the options trading strategies commonly used by institutional investors. It is known as uncovered options trading and as naked options trading. In a majority of situations it is not available to the retail traders simply because of the margin requirements on selling options short. Some options broker may require $100,000 in the trading account in order to allow uncovered options trading.

Why is selling options short so attractive to the institutional investors? In fact the uncovered option trading has a bigger risk of unlimited losses and limited possible gain. The maximum gain an options seller may receive is the 100% premium paid for the sold options and the maximum loss is theoretically unlimited. On the other hand the options buyer may experience only 100% of the premium paid for options as a maximum loss and the potential profit is theoretically unlimited. Still it does not stop institutional traders from selling options short.

The answer is simple. If you compare 2 completely similar trading systems with the only difference being that system #1 sells options while system #2 buys options, you will see that the probability of making profitable trades is higher for system #2 (uncovered options trading). In addition the trades delivered by system #2 will be more profitable than the trades generated by the system #1.

The fact that selling options is more profitable than buying options is easy explainable by the nature of the options. Options loose value with time. The closer options are to the expiring the cheaper options become. The time erosion is an options seller ally and plays against an options buyer. Even if the underlying security moves somewhat against the direction of the short position, the sale of short options can still bring in a profit due to an option’s time value erosion. On the other hand as a general rule, the longer an option buyer stays in a position, the greater the risk that the purchased option will drop in value - even if the underlying security moves slightly in favor of the position.

By the affect of time erosion on the benefits of selling short options and of buying long options, it becomes evident that option sellers have more opportunities to profit. Option sellers only lose money if the underlying security moves substantially against their position (i.e., contrary to the predicted direction). In flat markets – or when the underlying moves modestly against one’s position – it is still possible to make money (because of an option’s time erosion which benefits the option seller).

On the other hand, option buyers have the advantage when it comes to limiting their potential losses. When selling options short, traders risk losses that can far exceed the amounts originally required to establish the position. In contrast, an option buyer’s risk is limited to the amount of the premiums paid.

In summary: Option sellers have more opportunities to profit, but they face the risk of larger potential losses. In some situations, losses may be mitigated by the use of a stop-loss strategy.

Index options are safer than individual equity options in this respect as there are no mergers or buyouts where a stop loss may be meaningless if trading is halted before an announcement is made.