By Josip Causic, Online Trading Academy Options Instructor
This article will highlight the difference between being an option buyer and an option seller (casino).
Many times as the plane is landing in Las Vegas, and the passengers are viewing the Strip below, the captain makes a very attention-grabbing remark. "Just remember, these Casinos weren't built by the winners' money." One might wonder what this has to do with option trading? Everything. Another similar saying by Benjamin Franklin was: "There are only two things that are certain in life: death and taxes." I dare add that there is actually another component that is absolute – time passage. Thus going back to Ben's saying: it is death, time, and taxes that are absolutely certain in life. Again, one might not instantly see the connection between the two, time passage and option trading, but it is there.
One of the easiest ways to point this out is by comparing the option premium to an ice cube. In fact, in my classes I often ask my students whether they are open-minded to be taken out of their comfort zone. When I receive an affirmative answer, I reassure them that the stock market has a way of taking anyone out of his or her comfort zone. Then I proceed by asking them to take an ice cube from me and hold it in the palm of their hand. By the time I am done distributing the cubes from my ice bag, some of the students start objecting and questioning the point of the activity. After all, the warmth of their palm has melted the ice cube already, and their hands feel uncomfortably wet. At that moment I make a comparison between option premium and the ice cube. The melting of the cube is unstoppable. Just as none of us are getting any younger, the ice cube in their hands "ain't getting no bigger" (as some would say). However, instead of seeing this as a negative thing, we as the option traders could turn the tables around and see time passage as something positive.
What if we were the seller of option premium? This might sound like a revolutionary concept to many novice traders but the fact is that an activity of trading is always a two-sided activity. Whenever a trade takes place in the stock market, there is an invisible "handshake" between a buyer and a seller. However, due to our North American culture, we are more accustomed to buying. Moreover, we as a nation tend to buy at the asking price without any negotiation. Buying comes to us more naturally than selling.
In the stock market, a trader could go short by borrowing the shares of stock from his or her broker. He or she is essentially selling the shares at the higher prices and then later on buying them at the lower prices. In the option environment, the procedure is the same. We sell something that we do not have as long as we have capital in our account to cover the expense. This activity is called going naked or being un-covered. It is possible to sell a naked call or to sell a naked put, yet I always discourage my students from doing it. This might sound like a contradiction, for I do advocate selling of premium, but at what expense is the key thing. If I am going to be overly exposed, or naked/uncovered, then the risk does not outweigh the reward. Spread trading is the way to go, specifically credit spread trading. When we sell a credit spread, our risk and reward is clearly defined, and as long as our technical analysis is accurate, the time decay will work to our advantage.
In conclusion, the stock market goes three directions: up, down, or sideways. Yet out of those three, it mostly goes sideways as it has been going this past week. By being a casino, or seller of options with the defined risk and reward, we are ensuring the fact that we will live to trade another day. Casinos are going to outlive all of us.
- Josip Causic
jcausic@tradingacademy.com
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