Buying vs. Selling Options: Which Is Riskier?

The severity of risk in trading depends on the preferences and objectives of the trader. Buying options tends to be less risky than selling options from the perspective of a trader who’s making a single trade. Your risk is limited to the premium you paid for the option contract because the most you can lose is 100% of your investment if the option expires worthless. The dynamic is reversed when you’re selling options.

Option sellers tend to win more trades than they lose but the losses are larger. An option seller might feel that they’re taking on greater risk because the losses could be larger. The trade even has unlimited risk in some cases.

Key Takeaways

• Options are contracts that grant the right but not the obligation to buy or sell an asset at a predetermined price.
• Buying options involves the risk of losing the initial premium but it offers the potential for unlimited gains.
• Selling options can generate immediate income but it exposes the seller to potentially unlimited losses.
• It will limit both their upside and their downside if sellers also buy other options to make spreads.
• Both buying and selling options have their advantages and pitfalls.

What Are Options?

Options are financial derivative contracts that give buyers the right but not the obligation to buy or sell an underlying asset at a predetermined price known as the “strike price.” They must do so on or before a specified date. The underlying asset could be a stock, bond, commodity, currency pair, or index. There are two main types of options: calls and puts.

Call options provide the holder the right to buy the underlying asset. Purchasing a call option on a stock gives the owner the right to buy that stock at the strike price before the expiration date.

Put options give the holder the right to sell the underlying asset. The seller of a call or put option is obligated to sell or buy the underlying asset if the holder chooses to exercise the option.

The buyer of an option pays a premium for the right to choose the price of the option. The seller receives this premium in exchange for the obligation to fulfill the contract if it’s exercised. This dynamic sets the stage for the varying risk profiles of buying and selling options and shapes the strategies traders employ to capitalize on market movements or to generate income.

Options can be used to speculate on the direction of markets or to hedge an existing position in the underlying asset.

A trader might buy a call option if they expect the stock price to rise. An investor might buy put options to protect against a potential downside in a stock they own.

Understanding Options Risks

An option seller receives the premium upfront but they’re obligated to buy or sell the underlying asset at the strike price if it’s assigned. This exposes you to unlimited risk if the market moves against your position. Selling options can generate income from collected premiums but it requires more experience and risk management to limit losses from adverse price moves.

Option buyers take on defined, limited risk. You pay a premium upfront and your maximum loss is limited to 100% of that premium if the option expires worthless.

Option sellers take on an undefined, potentially uncapped risk if the market moves against their position. Selling options can generate income from the premiums received but it exposes the seller to large losses if they’re assigned on the contracts.

Risks When Buying Options

Buying options isn’t without risk. You could lose 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.

The phenomenon known as “time decay” works against option buyers as well. The value of an option naturally deteriorates as its expiration date nears so you not only have to be right about the direction in which 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.

Options are highly sensitive to volatility. Increased volatility can boost the value of an option you’ve bought but 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. Trading options also often involves additional costs such as commissions and fees which can eat into any profits you might make or exacerbate your losses.

Risks When Selling Options

Selling options comes with the possibility of unlimited losses but the risk profile is often more nuanced than this suggests. Many sellers employ strategies that can mitigate some of these losses such as using stop-loss orders or selling options as part of more complex strategies. These might include spreads or covered calls that can limit the downside.

The term “unlimited losses” might imply that these losses can skyrocket to staggering sums in a very short period but this usually isn’t the case.

Important

It’s crucial to remember that the premium received is generally much smaller than the potential loss. It serves more as a buffer than a safeguard against significant losses.

The market in the underlying asset will often have its own set of checks and balances. Extreme moves in underlying assets often trigger trading halts or other mechanisms that are designed to cool down overly volatile trading. Many options contracts are never exercised. They expire worthless or are closed out before expiration.

The theoretical risk is unlimited but the practical risk is often less dire than it might appear. Selling options can provide a cushion against losses due to the upfront premium received. This premium offsets some of the risk and can turn what would have been a losing position into a break-even or slightly profitable one.

Pros

• Unlimited upside potential

• Limited downside risk

Cons

• Can lose the entire premium if the option expires worthless

• Option premium can be expensive

• Options prices decay over time

Pros

• Can collect the entire premium as income earned

• Benefit from time decay

Cons

• Unlimited potential losses

• Gains limited to the premium amount

• Requires margin and may entail margin calls

Is Buying or Selling Options Right for You?

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.

Buying options is often the best way to go for novices and holders of small accounts. Beginners might find that buying options is 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. It’s generally more suitable for experienced traders.

Selling options and especially “naked” unhedged options often requires a margin account and a significant amount of capital that you can set aside as margin. This capital requirement could be a limiting factor if your trading account is relatively small. Buying options doesn’t have this requirement, making it more accessible for traders with smaller accounts.

Selling options might be more appealing, however, if you’re looking to generate immediate income. You receive the premium upfront. This could be an option if you’re a more sophisticated trader with the resources and understanding to manage your risk.

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 because you’re not required to purchase the stock at market price if the option is exercised. This strategy does cap your upside potential, however, because you’ll be obligated to sell your stock at the strike price if the option is exercised. You could potentially miss out on larger gains.

Selling an Option or Shorting a Stock

Selling a call option and shorting a stock both involve betting on a decline in asset value. Selling a put would be a bullish position. They’re fundamentally different strategies with distinct risk profiles, however.

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

You’re selling someone the right to buy or sell a stock at a certain price when you sell an option. You receive a premium upfront and you must buy or sell the stock at the strike price if the option is exercised. Selling a call option also exposes you to potentially significant losses if the stock price rises sharply. Selling a put option exposes you to significant but not unlimited losses because the stock price can only go down to zero.

Option contracts have expiration dates but short positions in stocks can be held indefinitely. Both strategies aim to profit from asset depreciation but they operate under different mechanics and come with unique risks and obligations.

Can You Combine Buying and Selling Options?

Yes, there are more complex strategies that involve both buying and selling options. They include spreads, butterflies, and iron condors. They can be used to hedge against risk, capitalize on volatility, or generate income. They often require a deeper understanding of options, however, and they may involve multiple transactions, increasing your exposure to fees and complexity.

Buying often offsets some of the risks of the short option and selling offsets some of the costs of buying the long option.

What Happens If My Options Expire Worthless?

You lose the premium you paid for it if you’re the buyer and your option expires “out of the money” or worthless. You get to keep the premium received if you’re the seller and your option expires worthless. Your obligation to buy or sell the underlying asset is nullified.

Can I Exit an Options Trade Before Expiration?

Yes, you generally can exit an options trade at any time before the contract expires for American-style options. This can mean selling the option back to the market if you’re the buyer and it’s gained value or you could simply let it expire if it hasn’t. Sellers can buy the same option contract to offset their original position, effectively closing it out.

Exiting early can be a way to secure gains or minimize losses but it’s important to consider the costs that might be involved such as additional commissions or fees.

The Bottom Line

Options trading is a double-edged sword, offering both opportunities and pitfalls, but buying options is generally less risky than selling them. Buying options limits your downside but selling them can lead to potentially unlimited losses. You can navigate the risky but rewarding world of options trading more confidently when you understand these aspects.

Disclosure: Investopedia does not provide investment advice. Investors should consider their risk tolerance and investment objectives before making investment decisions.