Is it easier to profit from selling, than buying, options?

Question

Reasons 1-3 and 4-6 below look correct. Is the author's conclusion correct though?

To make a profit on the buying side:

1. You have to be directionally correct. The price must go up for calls, down for puts.
2. AND the share price move must be bigger than the premium you paid.
3. AND the share price move must happen before the option expiration.

You will notice that it is pretty unforgiving. Sure, when you are right, you can make a 100% to 1000% profit in a few months, weeks, or even days. But there is a big chance that you will suffer death by thousands of cuts with your long call or put contracts losing value every day and become worthless.

We were discussing earlier how volatile stocks can have a high extrinsic value. What happens to your option price if the share is changing a lot and suddenly calms down? The extrinsic portion of the option price will crater quickly because volatility dropped, and time is still passing every day.

The same way you can buy options, you can also sell call and put options. Instead of buying the right to exercise your ITM calls and puts, you sell that right to a 3rd party (usually market makers).

To make a profit on the selling side:

4. You have to be directionally correct.
5. OR the share price does not move as much as the premium.
6. OR the share price does not move before the option expiration.

Buying calls and puts mean that you need to have strong convictions on the share’s direction. I know that I am not good at predicting the future. However, I do believe in reversion to the mean (especially in this market :)), and I like to be paid as time is passing. In case you didn't guess yet, yes, I mostly sell options, I don’t buy them. This is a different risk, instead of death by a thousand cuts, a single trade can have a big loss, so proper contract sizing is really important.

It is worth noting that because you sold the right of exercise to a 3rd party, they can exercise at any time the option is ITM. When one party exercises, the broker randomly picks one of the option sellers and exercises the contract there. When you are on the receiving end of the exercise, it is called an assignment. As indicated earlier, for most parts, you will not be getting assigned on your short options as long as there is some extrinsic value left (because it is more profitable to sell the option than exercising it). Deep ITM options are more at risk, due to the sometimes inexistent extrinsic value. Also, the options just before the ex-dividend date when the dividend is as bigger than the extrinsic value are at risk, as it is a good way to get the dividend for a smaller cash outlay with little risk.

Answer 1

The logic given in the question is inadequate, since it misses the point that upside potential in long option positions is much higher than the upside potential for a short option position.

If one were buying/selling options at fair value on instruments that followed the random process used to price the options, a long or short position should not have an advantage over the other. The higher chance of a short position being profitable at maturity is offset by lower profits.

However, in the real world, options can be mis-priced, such as under-valuing extreme events. Furthermore, implied volatility is quite often higher than realised, which is equivalent to there being a risk premium. Those real world pricing discrepancies need to be looked at to discuss the relative merits.

Answer 2

The author is wrong on many accounts.

For the buy side, #2 is incorrect (share price move must be bigger than the premium you paid). For example, if I buy an ITM option for $2.50 (50 cents time premium), all I need is 50 cents of price rise by expiration to break even. I'll break sooner if the underlying moves up earlier than expiration.

For the sell side, #5 is incorrect (share price does not move as much as the premium). When you sell, decay is in your favor. Share price does not have to move to win and it can even move somewhat against you can still profit.

The same way you can buy options, you can also sell call and put options. Instead of buying the right to exercise your ITM calls and puts, you sell that right to a 3rd party (usually market makers).

It is worth noting that because you sold the right of exercise to a 3rd party, they can exercise at any time the option is ITM.

It's a 2nd party. 3rd parties occur when options change hands.

When one party exercises, the broker randomly picks one of the option sellers and exercises the contract there.

True but the first step in the process is that the OCC assigns positions randomly via a "wheel" algorithm.

Also, the options just before the ex-dividend date when the dividend is as bigger than the extrinsic value are at risk, as it is a good way to get the dividend for a smaller cash outlay with little risk.

For a put, if the dividend is greater than the time premium, there's the possibility of an arbitrage. This is not true for a call.

Answer 3

According to the Efficient Market Hypothesis, if the probability of a gain is greater than the probability of a loss, then the amount of the loss is greater than the amount of the gain. (That's simplified a little bit, since there are different amounts of possible gain/loss, each with different probabilities, but the general concept holds).

So this writer's argument is flawed in two ways: first of all, usually winning is not an argument for taking a particular type of bet. Second, whether a bet usually wins is tied to its payoffs, not whether it's writing or buying an option. If you're selling out of the money calls, then you will usually make money. But if you're selling in the money calls, you will usually lose money.

To the extent that the market is not efficient, it's arguably inefficient in that people like bets with steady payouts, and thus such bets are overpriced, which argues against this writer's position.

Also, believing in regression to the mean in the context of the stock market is silly.