The Three Critical Reasons This Finance PhD Prefers Selling Options

A 20-year trading veteran breaks down extrinsic value

• Options buyers can make money only from the directional move in the stock.
• Options sellers can make money from not only the directional move in the stock but also from time passing and volatility contracting.
• Given the nature of the market and options expiration, both time and volatility are working on the side of the options seller.

Should you buy options or sell options? From our perspective at tastylive, selling options is clearly the better choice.

If I buy an option, I need the directional move as measured by delta to be the main driver of my profitability. So, I need to get the move in the stock correct. Otherwise, I’m not going to make money. The other main profit drivers (time as measured by theta and volatility as measured by vega) won’t be strong enough to overtake a delta move against me and, generally speaking, theta and vega are working against the options buyer from the beginning.

If, on the other hand, I sell an option, getting the directional move correct will certainly help me, but I don’t necessarily need it to be profitable. In other words, I can be wrong directionally in the stock and still make money. The reason is theta and vega are actually working for me, rather than against me.

Extrinsic value and options prices

The key to understanding the multifaceted relationship among direction, time and volatility is that options are uniquely different from stocks. Options have an expiration date, while stocks do not. Options always cease to exist on that expiration date, but stocks can live on indefinitely. Options prices are based on two components: intrinsic value and extrinsic value. Stock prices have only intrinsic value.Investors often refer to options as “decaying assets” because at expiration all of the their extrinsic value must be gone. That leaves only intrinsic value in the options price—similar to stock.

Options sellers can advantage of this extrinsic value drop over time without needing a directional move in the stock.

Because that extrinsic value must be zero at expiration for all options, as time goes by, all other things being equal, extrinsic value slowly dissipates. Every day is not the same, and this decay does not follow a linear path. But if you sell an option, your objective is for the option price to fall, so you can buy the option back at a lower price than you received when you sold it. Therefore, this downward pressure on extrinsic value is naturally suppressing that option price. This works in your favor as the options seller.

Volatility contraction and option prices

Similarly, options prices respond to changes in volatility. Increases in volatility lead to increases in options prices, while decreases in volatility lead to decreases in options prices. Therefore, as an options seller, I much prefer for volatility to move lower—for the same reasons that extrinsic value falling over time helps me—both lead to lower option prices. Well, as luck would have it, volatility is usually in a state of contraction, as the positive drift in the market slowly pushes stock prices higher over time. 

So, if you buy an option, you have one way to make money, but if you sell an option, you have three ways to make money.

Jim Schultz, a quantitative expert and finance Ph.D., has been trading the markets for nearly two decades. He hosts From Theory to Practice, Monday-Friday on tastylive, where he explains theoretical trading concepts and provides a practical application of those concepts to a trading portfolio. @jschultzf3

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