What’s the better strategy?
Is it better to buy options or sell options?
Most new option traders don’t even know that selling options is even a thing. If they do, they are probably like I was when I first started trading options, scared of the possibility of unlimited losses. But then traders discover covered calls, and maybe cash secured puts and selling doesn’t seem that scary. When you realize all the benefits and risks of the many different ways to trade options, at some point you come back to the question of debit vs. credit option trades.
You might be asking, what does it mean to do debit or credit trades? The terminology comes from accounting where assets are debits and liabilities are credits. When you buy options, you pay a debit. You own the option which is an asset. When you sell options you collect a credit. You have the liability of delivering something to the buyer if required.
Option spreads add more nuance to the discussion. When you trade spreads, the combination of buying and selling either ends as paying a net debit, or collecting a net credit.
The trade-off
There is a fundamental trade-off between buying and selling options. When you buy, the big advantage unlimited gains with limited losses. The negative side of buying options is that probabilities of making a gain are low, and the probabilities of really big gains are very low. Sellers of options have the opposite situation- the probability of profit is usually high, but when losses occur, they can be very large and essentially unlimited risk.
One challenge when comparing between debit and credit trades is that it is a sliding scale that can allow traders to tweak in how much of the pro and con of each type of trade they want to take. For example, some sellers sell extremely high probability trades that take in a little credit each time and almost always end in small profits, but occasionally the trade becomes a huge loss. On the other hand, most debit traders know that they will lose more often than they win, but expect that the wins will be so big that it will outweigh the more frequent losses.
Time Decay / Theta
When discussing options, we must always consider the impact of decaying time value. Theta is the Greek associated with time decay of an option and represents the daily loss in premium from an option, assuming nothing else changes. For option buyers, time decay / Theta is constantly eating away at the value of the option, and buying strategies are generally best that minimize Theta. For option sellers, Theta decay is the goal- sellers want premium to decay, so finding strategies that maximize decay becomes a key driver.
Theta is greatest as expiration approaches, and is also greater at strike prices closest to the current underlying trade price. Different strikes and times to expiration can have better probabilities than others, based on whether the option is being bought or sold. Theta acts a little differently with spreads than with naked positions, but with mostly similar considerations.
Expiration
For options on stock and ETFs, expiration means settling by assigning shares, or having options expire worthless. Call option buyers that have options expire in the money get to purchase shares at the strike price of the option from option sellers. Put option buyers that have options expire in the money get to sell shares at the strike price to put option sellers. Technically, the buyer has the “option” to execute the trade, but most brokers automatically execute the option if it is in the money for the option buyer. The option seller has no choice, they have the obligation to fulfill their end of the option contract.
All of this option execution can be mostly avoided by closing a trade prior to expiration. There are some situations where buyers may want to execute their option early, like to capture a dividend, or when an option is deep in the money and not very liquid, but experienced traders can usually see these situations developing and get out before they materialize. But having an option executed and being forced to buy or sell shares isn’t the end of the world- usually the trade can be quickly reversed without a lot of fuss.
Many new option traders think that the only way out of an option contract is to execute it. There are actually lots of choices. Buyers can sell their position, sellers can buy back their positions. Either type of trader can roll as well. These different choices are discussed more in the web page on holding, folding, and rolling options.
Probabilities
Traders can quickly get a good idea of the probabilities of an option expiring in the money by looking at the option Greek Delta. Delta literally is the probability that an option will expire in the money. For example a call strike with a Delta of 0.70 has a 70% chance of expiring in the money. This doesn’t mean that a trade will or won’t be profitable- a trader also has either paid money or collected a premium. A buyer needs the underlying price to move more than time value that was paid to be profitable, while the seller needs it to move less.
Because of skew and the fact that the market tends to trend upward over time, buyers of calls tend to have much better success than buyers of puts. Sellers of puts tend to do better than sellers of calls. It takes a very big move down for a put to go beyond the premium paid to be profitable. It often doesn’t take as big of a move for a call purchase to be profitable. However, timing and trade management can help in each case for both buyers and sellers.
Theoretically, premiums reflect equal gains and losses for each side of the trade, if played out over years or decades. For example, put buyers likely made big profits in 2020 during the Covid crash, but for most of the decade before and after, not so much. The extra premium that put sellers collect is because they are assuming the risk of the next big crash that may eventually come. On the other side, most securities don’t “crash” up, so calls don’t have a lot of implied volatility compared to puts in most cases. There’s less premium to overcome, and the trend up over time makes winning for buyers more likely than even Delta values would suggest.
Many traders focus on options that are out of the money to trade. Option buyers have two hurdles to overcome, they need the stock to move in price in the right direction, and they need it to move more than the premium has decayed at the time they close the trade. Option sellers have these situations reversed, they only need to have the stock move against them less than the amount that premium has decayed to make a profit. So for a put seller, they win if the market goes up, if the market stays the same, or even if the market goes down just slightly.
As a result, option sellers tend to have a high winning percentage on their trades, while option buyers have a low winning percentage.
Risk
There’s risk on both the buy side and sell side of options. That risk is balanced by probabilities so that in theory over time either side should face the same outcome. But the risk plays out in very different ways.
Buying options and spreads typically involves putting up a fairly small amount of capital with the potential to lose it all. It’s usually a series of small bets, but it depends on what debit strategy is being used. So buying option strategies is a risk similar to death by a thousand paper cuts.
Selling options is typically a high probability of trade. But the trade off is that when a trade loses, the loss can be much bigger than the premium collected to start with. Generally, the higher the probability of success, the greater loss there can be when the trade fails. Having a risk management plan is critical to long term success, or a greedy trader will eventually blow up an account.
For a detailed run-down on the different risk profiles with charts showing how basic trades can perform in different scenarios, see the page on risk by trade types.
Reward
The differences in rewards for debit vs credit are basically the opposite of the risk parameters.
Most debit trades have very big upsides. A trader purchases an option for a small premium with the hope that the value explodes to many times the purchase price. The odds may not be high, but when things go right, they go very right, multiplying the amount spent to start.
On the other hand option sellers tend to collect a little, make a little, time after time. It’s not a get rich quick scheme, but a gradual growth over time from small win after small win. It tends to be boring. Or traders that sell options want it to be boring.
Management
Managing debit and credit option trades also tends to require different approaches. With different risk and reward profiles, one size does not fit all trades.
With debit trades, success can be fleeting, with big gains that can quickly evaporate. Adjusting trades to take money off the table while still having the exposure to unlimited upsides tend to work well for winning trades. Traders with losing trades have to decide whether to manage losses or accept the full purchase price as a cost of being in the strategy. Generally, the decision is based on what level of capital was put in and the probabilities of turnarounds after the trade goes wrong.
For credit trades, the decision on winning trades is whether to let the trade expire worthless or take the win by closing and get out before expiration drama comes along. Losing trades need to have a plan for getting out or repositioning before losses get out of hand.
What is best?
While debit and credit trades can both work best in any market environment, there is a slight edge to consider. When implied volatility is high, options are expensive, so selling options tends to have better returns and less risk. When implied volatility is low, option prices are cheap, so buyers have a better shot at making money and not losing as much in time decay.
There’s no best way to trade options. Often it comes down to a style of trading that matches the strengths of the individual trader’s style of trading and risk tolerance. Keep records of trades and evaluate what works best in good times and bad. Let your choices be data-driven.
