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