I touched on this briefly in the last post in this series, Puts and Calls: Basic Options Primer, option buyers have greater reward potential and less loss potential. Sellers have a greater loss potential and limited reward potential. The market place requires that there are an equal number of buyers and sellers though (there can't be a buyer without a seller). So what motivates sellers to take what seems to be the short end of the stick? Probability Options prices are calculated by using the expected value of the option when it expires. Simplified, the seller takes (loss at a certain stock price)x(probability that the stock will reach that price) for every possible underlying price. This gives him the expected value of the option. Sellers like to sell options at a price slightly higher than this expected value, which they believe the deserve for providing the service to buyers. Buyers like to buy for slightly less than this expected value, because buyers like good deals. The seller is taking a calculated risk, based on his odds, then tacking on a little more to the price, to buffer his profits. The majority of out-of-the money options that are sold expire out-of-the-money, and therefore worthless. Thus, the majority of option trades result in the seller collecting a small amount of premium. Though sellers are normally the winners, they win small amounts each time. When they do lose though, they stand to lose a lot. Buyers on the hand, lose a little each time, but when they win, they stand to win a lot. Are You a Buyer or Seller? Let's imagine a simplified version of the casino game, roulette. In this game there are 36 outcomes, 1-36. Let's also say we only bet on single numbers. It costs 1 dollar to place a chip on a number. If the ball lands on your number, you win 36 dollars. Otherwise you win nothing. If you have the choice of being either the person running the wheel or the person playing the game, which would you rather be? The person behind the counter makes $1 every time someone places a bet but does not hit their number. The person playing the game pays $1 for the opportunity to play, and loses that $1 if he does not have the fortune of selecting the right number. Consider the risks and rewards: It is possible (though less likely) that a person will play the game once and win on the first try. Potentially for a $1 layout, $36 can be won. Its even possible to win two games in a row, winning $72 after paying $2. However, the odds are ovewhelmingly in favor of the player losing $2. On the other side of the table, the person running the game has probability on his side that he will most likely take home $2, because the player will most likely not his his numbers. However, it is possible (though unlikely) that the game could be won twice simultaneously and the owner of the game would lose $72, after collecting only $2. They are equally "risky" opportunities, but in different ways: in one case, there is a high probability of failure, but the small chance of a win represents a much larger payout. In the other case, there is a high dollar value at risk, but a very low chance that the loss actually occurs. Consistent, probable income with the small chance of large failure VS consistent probable losses with the small chance of a large windfall. If you would rather be behind the counter, you're risk personality is that of a seller of options. If you'd rather be playing the game, you're a buyer of options. This post is part three in a three-part series on investing using options: part 1 | part 2 | part 3 |
