Hey, this is Sasha Evdakov.
Today we’re going to cover a little question that I get quite often regarding options. If you’re getting started in options, it can be confusing.
We’re going to go through the charts and go on-screen, but before we do that, I want to make sure you understand that all the examples that we use are strictly for educational purposes.
None of this is recommendations to buy or sell any stock, security or option. I think most of you understand that.
Why Would Someone Sell a Put VS Buying a Call?
This is the question.
- Doesn’t the unlimited downside and limited upside to selling a put make it more risky?
Well, let’s take a look at the risk factor. When a person is new to trading, and they look at the absolute risk in a big picture way. They’re looking at it from a big point of view.
However, as one gets better at trading, they may look at risks in terms of probabilities or possibilities. What’s the possibility of something happening?
Selling a Put VS Buying a Call
If we look at selling a put versus buying a call the absolute risk on a bigger picture – selling a put is very risky.
However, you can define your risk based on the probability of where you sell that put (strike price) and how far out you go in terms of time (the month).
Take a look at this concept on screen. That way you’ll probably get a better idea if we use Facebook to give you a rough idea of where we are on the chart on Facebook. We’re currently right around the $130 range.
Let’s take a look here on Facebook. We go to trading this stock, and we go about 57 days out. I do buy a call, and then I go to a single, and then I right-click and analyze the trade.
You can see that the risk that I have available on this trade is right here. The risk that I have is $160. The way that I can see this is based on the premium that I pay. That is $160 or a $1.6 multiply that times a hundred because you control a hundred shares with one option contracts. And you get your $160 right there at that point.
That’s the max risk that you have on this which would be buying a call. And of course, your direction that you have is to the upside. You have unlimited profit potential. But as we know what the chances of that stock getting to 220 in the next 60 days are?
I mean it’s been moving and here since June – it moved about 10-15 points. Right now we’re in September. That means that the probability to hit 220 is not realistic. But anything could happen in the market.
In general, you’re risking $160 to potentially make whatever it is. It could be $3000 in the 170. At the 155 you’re making about $1480 or 145 you’re making $660.
I think it’s more realistic to look at 140 which would be about $360 and that’s without time decay. The thing about buying an option you have this thing called a Theta.
There’s our theta right there in which case every day that option premium decays $3.26. Now as we approach closer into this range, you can see that theta increases to $4.58.
That decay as we increase the data as well as continue to accelerate. You’re losing money every day. If you’re a rookie trader, the general thing that happens is that you’re losing money every day. Think about it. You’re putting on a position, and you’re going to lose money every day.
However, you can do something like this:
- analyze the trade
- go to a PUT
- go to 110 PUT
- go to sell this PUT
Keep in mind the stock’s current price is right around 130. Now we’re going to sell this put. The thing is with this stock is it appears like you have an unlimited loss.
Your losses are there only if the stock gets to zero. In this case, if you’re selling a put, you’re looking at right around $10,000. The thing is there are a few significant differences. You still have profit potential to the upside.
That means you’re still profitable to the upside but your decay your option premium. Now as you look at it is a positive $2.12. That way if the stock doesn’t move at all you make money. You make $2.12, and that continues to accelerate day in and day out as those days continue to move forward.
Whereas if we buy a single, you’re losing money every day. Yes, you have unlimited profit potential whereas on selling a put you don’t have unlimited profit potential. You’re making your $63. Of course, I could tighten this up to 115 and now would be a bit more.
It’s based on what I’m selling. It’s just like a business. A business makes money by selling things. Here we’re selling something at $1.09 giving me $109. If Theta stand still you’re making money.
Looking at these scenarios here’s what happens. If I buy a single, I lose money if the stock stands still. And if it goes against me, I lose money. I lose money on a day to day basis if it goes up.
However, I do have unlimited profits. It needs to get past this 141 break-even point which you can see indicated by that little hash mark.
That’s the case for me to break-even at expiration. Otherwise, you’re losing money day in and day out. But it does look more delicate in terms of unlimited profit potential.
What Are The Chances of The Stock Goes to 80?
You do have some unlimited risk if the stock goes to 80, but what is the chance of that happening?
Take a look at the weekly chart down at 80 it would be at multi-year lows. It would be a significant sell-off.
- Is it possible?
- What do most traders do?
Well, the professionals will still sell the premium. But if you’re worried about compensating for that unlimited risk, this is what you could do.
This is called a vertical. You would sell that 120, and you buy a put at 115, capitalizing on the net difference and now I kept my losses at $421. The maximum risking is 421, but I’m making about $80.
It’s looking about 15%, 18%, 14% on my investment. It’s not quite 25% because that would be a quarter. But now the stock can stand still. It can move up, and it can pull back.
And you’re still profitable, and you’d make your $80. In the other situation, the stock needs to move for you to make money. If it stands still, you’re at a loss. Maybe it goes up – you’re still at a loss.
Unless it goes up within the next few days, otherwise, you’re losing money every day.
Whereas in this scenario all of a sudden since your next seller the stock stands still you make money. If it goes up, it makes money. If it goes down, you make money.
The scenario where you lose money is if it goes down quite a lot in a shorter period. That’s why most people are sellers because like a business you want to sell products and items.
Things to Take Into Account
The software that I use on this was the thinkorswim platform. You can take a look at that, or there’s other option trading software that’ll give you profit and loss analysis pictures. In general, most traders as far as more active ones are looking to sell option premium. It’s just like a business – you want to sell products.
You want to be a net seller, and then you buy a little protection there to hedge for those losses. If you’re a rookie beginner thinking about it in terms of I’m only risking $100, and my theta is only $2.00 – it doesn’t sound like a lot.
But imagine putting on 5, 10, 50 of those trades consistently, and then you’re losing every day. Every day you’re losing money. That’s like basically taking out your wallet, and you take your money and throwing money all the time on these option contracts.
That’s not what you want to do. You want to instead collect that money by selling premium. That’s what you want to do.
In this post, we’ve covered a question that is crucial when it comes to options. That question is why to sell a put when you could buy a call.
We’ve used the thinkorswim platform. Throughout reading this post, you become familiar with terms unlimited and absolute risks as well.
Also, you’ve learned how to define your risk based on the probability of where you sell that put and how far out you go in terms of time.