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Buying Options vs Selling Options - Options Strategies - Options Trading For Beginners - YouTube
Channel: Option Alpha
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Hey everyone, it's Kirk here again at optionalpha.com.
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In this video we are going to go through the
differences between buying options and selling
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options.
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Now, as a quick review, there are only two
types of options contracts out there, calls
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and puts.
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Everything you can do in this space revolves
around these two types of contracts.
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Until now, in our track 1 here for beginners,
we've only really talked about options buying,
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not really talked about selling.
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We've mentioned that there's an options seller,
but it's kind of been like this person who's
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on the other side of the trade.
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We haven't really talked about how they can
actually build a position in a core position,
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selling options versus buying and how that
can be the basis for trading for income.
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Let's start with this table here, because
I think it goes through a little bit of the
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rights and responsibilities that we need to
be aware of as traders when it comes to buying
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or selling calls and puts.
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Now remember, there's two sides to every trade.
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So you always have a buyer, you always have
a seller, and then we can only ever trade
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calls and puts.
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There's really four, so there's really four
types of basic options that we can get into.
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We can buy calls and puts, or we can sell
calls and puts.
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In this case, the option buyer for a call
option has the right to buy stock at a certain
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price in the future.
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Now again, if you are an option buyer, you
are generally outlaying money in premium.
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So when you pay for something, you get back
a right for making a choice in the future.
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You're paying for that choice.
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So, again, as an option buyer, they have the
right to buy stock at a certain price in the
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future.
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Option buyers might buy a call option on a
50 strike stock and say they want to buy that
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stock for 50 dollars a share at any time in
the future between now and expiration.
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On the other hand, a put option buyer has
the right to sell stock at a certain price
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in the future.
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So again, they are still paying money to the
option seller, so they still get a right just
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like the call option buyer.
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But now instead of wanting to buy stock, they
want to have a guaranteed sell price at where
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they are going to sell that stock in the future.
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They might want to sell that stock at 50 dollars
and hope that the stock is trading for 30
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dollars, and they can buy it in the open market
for 30, and resell it for 50.
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Again, the key here with option buyers is
they pay money, they have to outlay the money,
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the cash, the capital, and for doing that,
they receive a right back from the option
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seller, or a choice back from the option seller.
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On the other side of the table here, we have
the option sellers.
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Now, the option sellers now have the obligation,
because they gave up their right to the option
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buyer.
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Now they have the obligation to sell stock
at a certain price in the future.
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But here's the key.
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Only if it's expiration, or they are assigned.
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So this is the key.
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It's not like this can happen at any point
and you give up, well it can happen at any
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point, but you don't give up your right to
do something with the actual options contact.
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You can close out of the options contract
and sell your contract to somebody else or
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buy back your obligation, you can do a lot
of things.
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The obligation to sell stock only happens
at expiration or if they're assigned early
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in the process.
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Now, we have more videos about the assignment
process here in the first track in module
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here in Option Alpha, and really most of these
assignments happen the last week of expiration,
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even the last few days.
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I don't want you to get totally, like your
feathers ruffled that this is going to happen
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immediately when you get into a contract.
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It does happen the last week, usually the
last couple days.
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Again, the key here is as an option seller,
you have an obligation to sell stock.
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If you agree with an option buyer, then they
are going to buy stock from you 50 dollars,
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you're going to sell it to them at 50, you
have to sell it to them at 50 if that contract
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actually comes all the way through expiration.
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On the put side it's the same thing.
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You have an obligation now as the option seller
of that put option.
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You have the obligation to buy stock from
that option buyer who is going to sell it
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to you, and whatever the predetermined price
is.
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So if that put option buyer says that they're
going to sell you stock at 50 dollars, then
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you have the obligation to buy stock at 50
dollars.
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Your hope as the option seller is that the
stock is worth more, because now you're going
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to buy stock at 50 and then resell it in the
open market for some higher price.
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But again, the key here is that the seller
is now collecting money from the option buyer,
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so money goes from the option buyer to the
option seller.
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And then the right gets transferred from option
seller to option buyer.
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So that's the cycle, that's the process.
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Again it works on both calls and puts.
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Now we also built this little graphic here
which I think is really cool.
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It's kind of like a four part graphic that
shows you kind of what you're expectation
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is for the actual underlying stock, whatever
you're doing.
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In this case, if you are, and let's just kinda
go through all these different examples, if
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you are a call option buyer, in this case,
then you are hoping that the stock price rises.
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That's your hope.
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You're buying a call option in anticipation
that the stock price is expected to rise in
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the future.
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If you are a put option buyer, then your hope
is that the stock price actually falls, so
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you want to see the stock price fall below
your strike price that you entered into.
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As a call or put seller, on either side, and
this is where we start to really distinguish
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the difference in this non directional trading.
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As a call or put option seller, remember that
you are taking in a premium and really the
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onus or the need for that option or that stock
to move, for you to lose that premium, is
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really on the option buyer.
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So by taking in that premium, you also get
the additional benefit because you gave up
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your rights for the stock to actually move
sideways and still make money.
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So in both the case of the call and put, if
the option were to move sideways, meaning
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to trade range bound or just move sideways
and not really trade higher or lower, then
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you would actually still make some money.
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As a call seller, you want the stock price
to fall.
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Remember, option buyers on the call side want
the stock price to rise.
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You want the stock price to fall.
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As a put seller, you want the stock price
to go up or generally stay sideways.
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And again we'll continue to go through many
many more examples but hopefully, this is
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a really good graphic that you can use.
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Print this out, put it by your desk, and use
it as you start to learn and develop a little
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bit more trading skill with whether you want
to be an option buyer or seller, calls or
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puts.
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This is a really cool graphic that we made
for you.
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Now let's review the differences between credits,
debits, and opening and closing when trading
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options, because now we're starting to get
a couple more choices or options, no pun intended,
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on how you can build different strategies.
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It's important to know how money is transferred
and how the order types go through.
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Here's the deal.
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It doesn't matter in this case whether you
are using this for calls or put options, because
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they work both the same way.
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It really depends on if you're going to be
long options, or short options.
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Meaning if you're going to be buyers, in this
case, buyers long, and sellers which is short.
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Let's go through some examples here, and we'll
use another graphic.
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This is a great little resource that you can
print out and put by your desk as well.
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If you are, let's say long, meaning buying,
and you want to buy to open, because that's
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usually how you start the option buying process.
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You have to buy to open a new position and
that's really the key here.
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You buy to open.
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Sometimes you'll see a broker platforms will
put in here BTC, which is, I'm sorry, BTO,
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we'll do BTC in a second, but BTO, which is
buy to open.
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Again, if you're going to buy to open something,
you're going to outlay money and that is called
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a debit.
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This means that you are paying money to the
option seller to open a new position.
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Okay?
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Now when you go back and you want to reverse
that trade, because again you have a choice
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to reverse that trade anytime between now
and expiration.
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You don't have to hold onto that trade all
the way through expiration.
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You can go back and remove your position and
kind of sell out of the position if you want
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to.
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You're still long the position initially,
but now you're going to go in and you're going
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to enter a sell to close order.
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Your broker might show this as STC, an STC
order which is sell to close.
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Don't get confused by the terminology and
all the acronyms.
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You understand exactly what it means, and
it's just logical progression and though process
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that we want to follow.
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We already have a long option, we want to
go back in and exit the trade.
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We want to use a sell to close order, and
when we do sell that option back to the market,
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we're going to hope that we collect a credit
for doing so.
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We're going to collect a credit, we just hope
we collect more than the debit.
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So in this case if we paid a debit of let's
say 5 dollars, we just bought an option for
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5 dollars, we hope that we collect a credit
when we sell it back of 7.
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Now we've realized a 2 dollar profit on our
trade beginning to end.
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We bought to open, then we sold to close.
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We paid 5 dollars then we received 7 at the
end.
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We ended up with a net profit of 2 dollars
at the end of the day.
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Okay?
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Just using basic numbers.
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On the other side, I you are going to be an
options seller first, meaning you are going
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to enter a short position, whether you're
shorting calls or shorting puts, you're going
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to enter that first order as sell to open.
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This is a little bit different and this is
where some people get confused, but again
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just follow me on this.
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An STO order, some brokers might show that,
some other brokers might now, but you're going
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to sell to open a new position.
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This is going to be the other position that
someone else bought on the topside.
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So an option buyer would buy to open, and
they would be opening in position with the
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an option seller who is at the same time,
opening a new position.
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So two people are opening a brand new position
on either side of the market.
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On this case you're going to take in a credit.
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Now remember the debit that the option buyer
paid was 5 dollars.
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You're going to take in that 5 dollar credit,
in this case with that option buyer.
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Later on if you decide to close out of your
position, again you're hoping that you can
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make at least 5 dollars on the trade, maybe
something a little bit less, but that's the
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maximum amount you can make.
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You can't make more than the credit that you
received on the trade.
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You're going to hope that you go back in,
again you still have a short position, and
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you're going to buy to close out of your contract.
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Again this is on some broker platforms going
to be a BTC, buy to close.
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You're going to buy to close and you're going
to pay a debit.
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You're going to hope that you collect, let's
say, a 5 dollar debit from that option buyer.
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Somewhere else down the line you buy back
your contract and close out of the position.
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Let's say it only costs you 3 dollars to buy
out of the position.
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Now you are left with a net profit of 2 dollars.
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Now you can see that option sellers or those
who are going short, no matter if you have
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calls or puts, want the future value of those
options to be less.
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Because if the future value of those options
is less then the credit that they initially
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received, that creates an opportunity to profit.
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With option buyers, you want to buy options
at 5, sell them at 7.
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With option selling, you want to buy something
at 5 and sell them at 3.
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I'm sorry, sell them at 5 and buy them at
3.
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Sell them at 7 and buy them at 5.
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Whatever the case is.
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So hopefully that makes a lot of sense.
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Again, it's all about these credits and debits.
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Debits you pay out, that's money out of your
pocket.
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Credit, that's money that you receive, you
get credit to your account.
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Again, if we have option buyers, just to use
a little bit more and drill this in, if you
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need it, if not you can skip through this
part of the video.
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If you are an option buyer, and this is your
contract, this is your option contract that
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you have.
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If you are going to buy an option, you are
going to give up some of that cash in exchange
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for getting that contract.
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Now you have the contract as an options buyer,
but you had to give up some of your cash to
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the option seller.
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So you paid a debit to get into this trade.
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The option seller received a credit.
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If they want to reverse the trade, now if
you're an option buyer and you want to close
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out of the position, you have to go out into
the open market, take your contract, and sell
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it to somebody else.
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That option seller, or new buyer in this case,
might then pay you your money back.
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So now you're getting a credit back and this
seller, if they're a new buyer they don't
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already have an existing position, they're
going to pay you some money, a debit, and
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you're going to receive your credit back.
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Okay?
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It's all this interaction between buyers and
sellers surrounded by this options contract
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that we have.
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Finally, let's quickly talk about trading
cash versus on or with margin, because this
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is a big topic and I want to make sure that
we cover this and talk through as much as
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we can on this video tutorial.
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Here's the main difference between them.
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I want to make sure you get the main difference
because there are so many different little
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innuendoes between different brokers and I
don't want to pick one broker and say that
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that's the way that they calculate margin
or how they do it.
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Because it is literally different between
this broker and that broker and your account
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and somebody else's account even within the
same broker.
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There's basic guidelines that most brokers
follow, but you'll want to check with them
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and know exactly how they calculate things.
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You'll start to see this as we go through
some live trading examples here at Option
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Alpha as part of these tracks.
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The first thing that you can do is you can
trade on cash.
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As the name suggests, you have to have the
cash to back the trade.
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This is usually required on net long options
and cash is usually required in IRA and retirement
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accounts.
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IRA and retirement accounts have a little
bit more of a strict policy on the type of
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risk that you can take, meaning you can't
trade naked options or undefined risk trades
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in a retirement account because mainly you
can't trade on margin in those accounts.
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So with cash, if you're going to go out and
you're going to buy an option contract and
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the option contract is 100 dollars, then you
have to pay the 100 dollars to get into that
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option contract.
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Same thing in an IRA account.
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If the option contract is 100 dollars, you
gotta have the cash to back it up as far as
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a hundred dollar trade.
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If you go out and you enter a credit spread,
or a type of a spread which we'll talk about
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here later on.
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Let's say the risk in that trade is 500 dollars,
I'm just using round numbers, then you have
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to have 500 dollars to back up the maximum
potential risk in that trade.
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If the maximum risk in a particular trade,
whether it's a regular long option or a credit
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spread, or something else, if the maximum
risk is 500 dollars, you've got to have the
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cash in your account to cover that risk.
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Same thing goes with an IRA.
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If the maximum risk is 500 dollars, you better
have 500 dollars in your account to cover
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that trade, or you won't be able to place
the order.
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You won't actually be even at a point where
the broker allows the order to go into the
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open market to be placed.
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This is different than trading on margin.
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Margin is when you borrow or you have less
money put up than the maximum amount of risk
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in the trade.
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This is why we talk a lot at Option Alpha,
about keeping your position size small, keeping
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your overall allocation small, because margin
can expand.
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I've done podcasts and video tutorials on
that which you can definitely check out.
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But margin is basically borrowing money or
trading with a little bit of help from the
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broker.
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In this case, it usually happens more often
upon net short positions.
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So if we are a call seller or a put seller,
we might have to enter that contract and we
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might have to put up what's called margin.
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So we put up some portion of the maximum amount
of risk on the trade to cover this.
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This usually does not occur in any IRA or
retirement accounts, so just forewarning you,
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you have to usually have cash backing it or
the cash value of the maximum risk in IRA
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accounts.
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Let's go through a quick example here.
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Let's say that we are an option seller and
we collect a 100 dollar premium, selling an
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option from an option buyer.
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That option buyer might pay cash for that,
we collect that 100 dollars of cash.
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Now that we're an option seller, let's say
the maximum risk on the trade is 1 thousand
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dollars.
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Meaning, at the worst possible point, we could
lose a thousand dollars on the trade.
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Well, if we are trading on a margin account,
or we have a higher trading level approval,
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we can then go out and the broker can help
us and say, you know what, we're not going
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to require that you have a thousand dollars
in your account initially to enter this position.
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We might only require that you have 700 dollars
in your account.
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So now we're trading on margin, meaning the
broker is not going to require us to carry
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the full risk in the trade initially.
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Don't get confused here, because if the trade
starts to go against you, you still can lose
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the maximum amount for that particular trade.
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I'll show you later on in video tutorials
how we figure out what that amount is, but
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you can still lose that maximum amount.
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Don't assume that what the broker carries
in initial margin requirement is going to
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cover all of your risk in the trade.
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This is again mostly with net short option
positions, not net long option positions.
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This is helpful because as you trade on margin,
now you could potentially make 100 dollars
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on 700 dollars of your account being margined.
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Or a much better return than say, making 100
dollars on 1000 dollars of your account being
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margined.
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It's a little bit more of that added leverage
potential that your broker is going to look
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at.
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Another thing that most brokers look at is
what's called portfolio margin.
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As you get into higher trading levels and
higher account approval levels, they'll start
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to offset different positions.
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If you have a position in oil, and you have
a position in say, gold, they might look at
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those positions and say you know what, you're
position in oil offsets some of the risk that
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you have in gold.
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For both positions we're going to keep dramatically
less money in margin.
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Or we're not going to hold as much money because
they're uncorrelated and they don't really
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have an impact on each other.
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So there's a lot of different things there
that happen with margin accounts.
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Again, I want to go through some of the basics
here so you guys understand how cash versus
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margin accounts work.
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