How can selling options be more profitable than buying, despite unlimited risk for a seller?
Let us take an example of Bank Nifty Option.
Bank Nifty is between 29700–29800. My view is bearish.
I think Bank Nifty can fall till 29300.
I have two options:
Buy a 29500 put for let's say ₹100/- which will cost me ₹2,000/-. This is going to be maximum investment and maximum loss. My reward will be unlimited to the extent of fall in Bank Nifty. (Although there is no such thing as unlimited)
Sell a 30100 or 30200 call for let's say ₹100/- or ₹80/-, 1 lot of which will cost me ₹75,000/-. This is going to be the margin requirement. My reward is maximum ₹2,000/- or ₹1,600/- whereas my losses can be to the extent where Bank Nifty rises above 30180 or what people usually say unlimited (refer to last line of point 1)
Now my question to you is, in the two scenarios above, who is a wise trader?
Any trader who is new to options will declare that number 1 is wiser but the reality is totally different.
Here are few things to consider:
The point where max loss and max investment is ₹2,000/- and profit potential is unlimited; doesn't it sound too good to be true? If it is then why should Option Sellers actually exist?
For every buyer, there is a seller. You paid a premium of ₹2,000/- to the person who sold you an option. Or when I sold a call of 30000 or 31000, for a meagre profit of ₹2,000/-, I invested ₹75,000/-. Don’t you think that person who is willing to invest 37x more money in a trade compared to you; knows something that you don’t.
Further, do you think that a person who is willing to take risk of unlimited loss for profit of ₹2,000/- a fool. (well he is if he doesn't know what he is doing)
Firstly, option buying is too good to be true. Secondly, he does know something you don't. Lastly he is not a fool.
Option Buyer is a trader who predicts where the market will go. Option Seller is a strategist who predicts where the market will not go and plans accordingly.
Let me explain.
Option Buyer has only 2 options available with ₹2,000/- he invested:
Either hit a profit in which market needs to go exactly where he wants to. Rarely happens.
Either take a stop-loss or lose ₹2,000/-. Because even if trade goes sideways, just by the virtue of time decay, he will lose money and nothing can be done to protect it.
Option Seller has already shown that he has more money than an Option Buyer. So he can do following:
Even if market goes sideways from where he took position, he will be in profit because Option will be losing premium due to time decay.
Even if market goes against him SLOWLY, he has pretty good chance to be profitable because a slow opposite movement will not adversely affect option premium in opposite direction.
If the dynaimc of the market changes and market has a chance to move in opposite direction, he can sell a put of 29300 strike and convert his position into strangle. Now a little further upmove will be hedged by a sold put. Even a sold call can be squared off and stop-loss can be covered from sold put.
Did I say Option Seller has more money, so to hedge further, he can sell two puts to hedge losses on call.
Above the point 32000, which is breakeven point, he can buy a future and now it is no more a unlimited loss trade. It is fully hedged with 0 loss if held till expiry.
At any point if seller think market can break to upside, he can buy a 30300 call and convert the position into a spread which is again a limited loss proposition.
And adjustments can go on and on and on for an Option Seller. Did you notice how many options does a Seller has to save his position. Plus he has an edge of time by default in his favor which is against Buyer. Buyer has just 2 point of action.
For an Option Seller, its a strategy game. You got something for every scenario and even when the odds are against you, you can come out on top.
Every trade you take can result in 5 scenario:
If you can avoid no. 5 you will be profitable eventually.
Option Buyers go broke because they think small losses keeps them safe. But probability of these small losses is above 80% when they buy and hence they suffer loss too many times believing they will succeed and hence fail. Option Sellers at all times avoid big losses and focus on small calculated wins, probability of which is more than 80% and hence they succeed.
This pretty much sums it up.
I highly recommend you read this book Definitive Guide to Advanced Options Trading: A quantitative and no-nonsense approach to Option Selling for Income Generation
It has a complete approach on how to trade options. From analysis to position sizing to strategies and moreover, how to handle the worst-case scenarios. Small investment in knowledge can shorten the learning curve by a great extent.