Buying vs. Selling Options: Which Is Riskier? (2024)

Risk Evaluation When Buying Options

That does not mean that buying options is without risks. First, you have the risk of losing the entire premium you paid if the option expires worthless, which happens if the underlying asset doesn't move in the direction you were hoping for. This is particularly true for out-of-the-money options, where the chances of making a profit are statistically slimmer.

Second, the phenomenon known as "time decay" works against option buyers. The value of an option naturally deteriorates as its expiration date nears, which means you not only have to be right about the direction the stock will move, but also about the timing of that move. Every day that passes without significant movement in the underlying asset chips away at the option's value.

Third, options are highly sensitive to volatility. While increased volatility can boost the value of an option you've bought, decreased volatility can do the opposite, even if the underlying asset moves in the direction you anticipated. This is known as "volatility risk" and it can be a double-edged sword for option buyers. And remember, trading options often involves additional costs, such as commissions and fees, which can eat into any profits you might make or exacerbate your losses.

Risk Evaluation When Selling Options

While selling options comes with the specter of unlimited losses, in reality the risk profile is often more nuanced than that simplistic description suggests. For example, many sellers employ strategies that can mitigate some of those potential losses, such as using stop-loss orders or selling options as part of more complex strategies like spreads or covered calls, which can limit the downside.

Moreover, the term "unlimited losses" might imply that these losses can skyrocket to staggering sums in a very short period, which is usually not the case for several reasons. First, the market in the underlying asset will often haves its own set of checks and balances; extreme moves in underlying assets often trigger trading halts or other mechanisms designed to cool down overly volatile trading. Second, many options contracts are never exercised, as they expire worthless or are closed out before expiration. This means that while the theoretical risk is unlimited, the practical risk is often less dire than it might initially appear.

Is Buying vs. Selling Options Right for Me?

The decision to buy or sell options isn't one-size-fits-all; it varies based on your investment goals, risk tolerance, market outlook, and even your level of trading experience. For most novices and small account holders, buying options is often the best way to go.

This is because options trading is complex and demands a good understanding of the market and trading strategies. Beginners might find buying options to be more straightforward because the concept of paying a premium for the potential of larger gains is easier to grasp. Selling options often involves more complex strategies and requires a deeper understanding of market mechanics, making it generally more suitable for experienced traders. Plus, there is that possibility of large losses.

Selling options, especially "naked" (unhedged) options, often requires a margin account and a significant amount of capital to be set aside as margin. If your trading account is relatively small, the capital requirement could be a limiting factor. Buying options doesn't have this requirement, making it more accessible for traders with smaller accounts.

However, if you are looking to generate immediate income, selling options might be more appealing because you receive the premium upfront. If you are a more sophisticated trader with the resources and understanding to manage your risk, this could be an option. One balanced approach to consider is writing covered calls on stocks you already own. This lets you pocket the premium upfront while mitigating some risks, as you're not required to purchase the stock at market price if the option is exercised. However, this strategy does cap your upside potential, as you'll be obligated to sell your stock at the strike price if the option is exercised, potentially missing out on larger gains.

Selling An Option or Shorting a Stock: How Are They Different?

While selling a call option and shorting a stock both involve betting on a decline in asset value (selling a put would actually be a bullish position), they are fundamentally different strategies with distinct risk profiles.

When you short a stock, you're borrowing shares to sell with the hope of buying them back at a lower price later, pocketing the difference. The risk is potentially unlimited since stock prices can rise indefinitely.

On the other hand, when you sell an option, you're selling someone the right to buy (call option) or sell (put option) a stock at a certain price. In this case, you receive a premium upfront, and your obligation is to buy or sell the stock at the strike price if the option is exercised. Like shorting, selling a call option exposes you to potentially significant losses if the stock price rises sharply. However, selling a put option exposes you to significant but not unlimited losses, as the stock price can only go down to zero. Additionally, option contracts have expiration dates, while short positions in stocks can be held indefinitely. Therefore, while both strategies aim to profit from asset depreciation, they operate under different mechanics and come with unique risks and obligations.

The Bottom Line

In general, buying options is less risky than selling them, all else equal. Options trading is a double-edged sword, offering both opportunities and pitfalls. While buying options limits your downside, selling them can lead to potentially unlimited losses. By understanding these aspects, you can navigate the risky but rewarding world of options trading more confidently.