[Options ABC] Buyers VS. Sellers: How Much Do You Know of Returns and Risks?

Hello everyone and welcome back to moomoo. I am options explorer. In today's [Options ABC], we'll be taking a look at the risks and returns of options trading for buyers and sellers.

Let me ask you a question: do you remember your first options trade? Were you a buyer or a seller?

Many investors likely started as buyers because being an option buyer typically offers significant profit potential and limited risks when compared to selling options.

On the other hand, some investors are intimidated by the idea of being an option seller, as it can mean limited profit potential and unlimited risks.

But hold on, let me ask you another question: aren't profits and risks always present together? If so, how can an unlimited profit potential and a risk defined profile occur simultaneously?

In today's [Options ABC], I invite you to explore the risks and rewards for both options buyers and sellers.

As an options trader, it's vital to understand these important points: option buyers generally have a higher profit potential and limited risks, while option sellers typically have a limited profit potential and may have significant or even unlimited potential risks.

At this point, some investors may believe that the benefits of being an option buyer are much better than those of being an option seller.

Remember, every options contract involves both a buyer and a seller - they are two sides of the same coin.

To help illustrate, here's a hypothetical example. Alice anticipated that Nio's stock price would rise, so she spent $200 on a Call option expiring in 5 days. This option offered Alice unlimited profit potential, since the stock can theoretically rise infinitely, and limited risks, with the maximum loss being the $200 premium paid to open the position.

If you think the probability of success for Alice was 50%, you might get it wrong.
In fact, there were five possible outcomes:

1. The stock price of Nio rose slightly.
While this would benefit her Call option, the time value declined as the expiration date approached. Therefore, despite the slight increase in price, Alice's Call might still lose money due to the loss of time value.

2. The stock price of Nio fell slightly.
Alice bought a Call option anticipating a rise in stock price, but the opposite happened. As a result, the Call's intrinsic value declined, and further loss will be incurred as time passes by.

3. The stock price of Nio rose significantly.
This scenario would yield a profitable outcome for Alice, as the Call's intrinsic value increased along with the rising stock price.

4. The stock price of Nio fell significantly.
If the stock price dropped below the strike price, the Call would lose all of its intrinsic value.

5. The stock price of Nio remained stable.
In this situation, given the stock price did not change much, the intrinsic value would remain the same, and the time value would diminish gradually, causing a loss for Alice.
While call option buyers have limited risks and unlimited profit potential, their probability of success is usually lower than that of option sellers. Alice's experience shows that only one of the five scenarios may lead to potential profit.

On the other hand, option sellers have limited profit potential and unlimited risk, but generally a higher probability of success compared to buyers.

We've mentioned the concept of risk in options trading several times, but what exactly is risk?
Option buyers have limited risks because their maximum loss is known and limited to the premium paid to open their positions. Option sellers, on the other hand, take on a much higher level of risk. For example, if you sell an uncovered call, you face unlimited potential loss, since there is no cap on how high a stock price can rise.

While the future is uncertain, and options may not be appropriate for all investors, they are one of the more flexible investment choices available. Therefore, it's essential to manage risk carefully and control our positions appropriately.

Therefore, I believe risk should not be the sole factor to consider when making decisions. Position control and probability of success should also be taken into account.

It's important to note that I'm not advocating for everyone to become option sellers. At the end of the day, the investment strategy you choose should align with your goals and risk tolerance.

Suppose Alice wants to sell an option, what can she do to help manage her risks?

1) Position Control
As an option seller, Alice must ensure that she has enough margin to bear the worst-case scenario when selling options. If the margin falls below the brokerage's minimum requirement level, she will receive a Margin Call, which all traders should avoid.

Why?

A margin call is a demand from the brokerage firm to increase the amount of equity in investor's account. Investors can do this by depositing cash or marginable securities to their account or by liquidating existing positions to generate cash. Therefore, Alice must manage her positions carefully to avoid Margin Calls.

It's recommended to check your account's risk level on trading platforms like moomoo regularly. If you receive "warning" or "margin call" notifications, be aware of potential forced liquidation.

Liquidity is an integral component to options trading. Poor liquidity can lead to a wide bid-ask spread, causing traders to fail to execute options at their desired price in a timely manner.

For example, consider this Put option of Home Depot (HD) that expires on August 11th. You can see that buy and sell orders are few and the bid and ask spread is as large as $0.8 per share. In other words, the bid-ask spread of this Put option is up to $80, over 10% of the option's price!

Time is the enemy of option buyers but the friend of option sellers. Option value includes intrinsic value and extrinsic value (time value), with the latter decreasing rapidly as the expiration date approaches. In other words, every passing day means the option seller earns one more day of time value. As long as the intrinsic value of the option does not change significantly, the passage of time will cause the option's time value to decay at an accelerating rate.

Therefore, it's essential to be patient and befriend time when selling options. Learn from your experiences and potentially earn along the way.

That's all for today! Please feel free to leave a comment if you have any questions or thoughts. Don't forget to follow us to stay up-to-date on all things related to options trading. For more information of options learning, you can click on the image below to follow me immediately!