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This chapter is from the book

Buying Versus Selling

Which is better, to be a buyer or a seller? There are many factors that affect that decision, so there really is no "better." Both offer advantages and disadvantages.

The Buyer

The buyer has the advantage of potentially unlimited gains. He leverages his money through the purchase of options and can make returns several times his initial cost. He does, however, have a few things working against him.

Those who buy stocks have to get only one thing right: direction. If the stock goes up and they sell, they make money. Simple and uncomplicated. The buyer of options has to do the same thing, pick the right direction, but that's not all. He also has to be concerned with two additional factors: time and expiration.

Actually, picking the right direction is extremely difficult. An analyst who does nothing but study a certain company for years, talks to the CEO, knows the business inside and out, and even works at the company can still pick the wrong direction for the company's stock price. You, the ordinary investor, have access to no information that gives you an edge in the marketplace. Regardless, picking the correct direction is crucial for the stock buyer and also for the options buyer.

The options buyer can't just pick the right direction; he also has to pick the right distance the price will move. If he buys an option believing that Apple's stock price will go to $220, then Apple has to go to $220 and not just to $210. This is an example of getting the direction right but the distance wrong. Additionally, not only does the price of the stock have to reach $220, but the buyer also has to include the price of the option (for example, $5), which means the stock price has to go even further before he makes money. So you can be correct as to the strike price but can still make no money because you haven't covered your cost of purchasing the option.

Finally, the greatest difficulty the options buyer has to contend with is time. Correctly picking the direction and the strength of the move in that direction is worthless if the target is met after expiration day. If the market quickly moves favorably for the options buyer, there is a chance to make a profit if he quickly closes his trade. However, each day that goes by a little more value is lost in that option, making the likelihood of a profitable trade more remote if the stock doesn't do what the buyer hopes.

To review, the options buyer has to be correct about three things:

  1. Direction
  2. Distance
  3. Time

All three have to be in confluence to create a profitable trade for the options buyer. Some simple odds demonstrate the difficulty in getting all three of these correct. Attribute 50/50 odds to correctly choosing each of the three elements. But 50/50 is generous. Direction is either up or down but distance and time are far more complicated. What do we get? Direction (50%) x Distance (50%) x Time (50%) = 12.5%. At best the odds of holding a profitable option at expiration are about 1 in 8. You may think you have an edge. Study after study shows you really don't.

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