Giving Credit to Option Sellers: Do You Really Understand the Returns and Risks?

Today, let's delve into the risks and returns of option buyers and sellers.

First, a question: Think back to your first option trade. Were you a buyer or a seller?

LI Auto's stock price slightly falls. Despite buying a call option, if the stock price moves in the opposite direction, the option's intrinsic value decreases. Coupled with time decay, John could face losses.

LI Auto's stock price significantly rises. As we mentioned earlier, volatility presents opportunities. If John's call option appreciates along with the stock price surge, he's in a profitable state.

LI Auto's stock price significantly falls. No need to elaborate on this scenario. Picking the wrong direction leads to substantial losses as the stock price moves further away from the strike price.

LI Auto's stock price remains stagnant. In a scenario of no movement, time decay eats away at the option's time value. John would still face losses as time passes.

At first glance, it seems like option buyers have limited risks, with the maximum loss being the premium paid, and unlimited returns if they get the direction right.

However, looking at the winning odds, John might encounter 5 possible outcomes but only profit in 1.

In John's case, the seller of the call option has limited returns, with the maximum profit being the $200 premium received for selling the option. However, from a winning odds perspective, out of the 5 possible outcomes, only 1 results in a failure for the seller.

This shows that while option buyers have unlimited returns, their winning odds are significantly lower compared to sellers. Sellers have limited returns and potentially unlimited risks, but their winning odds are higher than buyers.

Now that we've explored the returns, risks, and winning odds for both buyers and sellers, let's talk about an intriguing concept: risk.

The risk for option buyers is limited because their maximum loss is known and limited; the risk for option sellers is unlimited because their maximum loss is unknown and potentially unlimited.

In a sense, we all live with risks because everything about the future is uncertain. We can't predict what we'll encounter when we step out the door, but we can't stay indoors forever because we fear risks. What we can do is strictly manage risk and position size.

Therefore, making decisions solely based on limited and unlimited risks isn't wise enough. Position control and assessing winning odds are more crucial.

Risk isn't an insurmountable obstacle; unlimited risk isn't necessarily scarier than limited risk. But I'm definitely not encouraging everyone to become sellers; all actions should be based on individual judgment.

Suppose John wants to become an option seller. What can he do to control his risk?

Position Control
For option sellers, it's crucial to ensure they have sufficient margin when selling options to handle worst-case scenarios. If your margin falls below the broker's requirements, you'll face forced liquidation (Margin Call), the nightmare of all option sellers.

Think about why? Once liquidated, option sellers must buy back an equal number of options to what they sold. The option premium paid becomes an expense, reducing overall profits. Therefore, if you want to be an option seller, you must control your positions carefully to prevent forced liquidation.
I strongly recommend all mooers to check your account risk status on moomoo. If you see warnings or danger signals, pay attention.

Focus on Option Liquidity
Option liquidity is crucial for trading. If liquidity is poor, the bid-ask spread widens, potentially leading to situations where trades can't be executed at ideal prices promptly.

Befriend Time
Time is the enemy of option buyers but the friend of option sellers. Why do I say that?

Don't forget, an option's value includes time value. As the expiration date approaches, time value diminishes rapidly. In other words, every passing day allows option sellers to collect time value. When the option's intrinsic value remains relatively unchanged, time decay causes the option's time value to decline rapidly in a parabolic manner. Ultimately, at expiration, the option seller of out-of-the-money options can pocket the option premium.

So, take it easy, learn to befriend time. Learn, trade, earn.

If any mooers have other ideas, feel free to discuss in the comments section.