Collecting Option Premiums with Limited Risk
12/24/2009 12:01 am EST
Options not only allow investors to make money on directional plays, they also allow you to profit when stocks don't move. In fact, options are the only way you can take advantage of the lack of movement in a stock. All you need to introduce yourself to the concept of premium collection.
Understanding the Risks
When selling options, first and foremost it must be stated and recognized that when you are short an option, you have an unlimited potential risk.
This is unlike buying options, where the buyer or owner of the option has risk that is limited to the amount spent to buy the option.
Before we go any further, I must note that the situation of potential unlimited risk is a very serious and dangerous situation for the individual investor. However, there are ways (strategies) that allow an investor to collect premium without having an unlimited risk scenario. It is imperative that you learn which of the premium collection strategies are hedged and which are not.
An individual investor should never invest his or her money in anything that puts all of that money in danger of loss. What's worse is that unlimited loss does not mean risking only the money invested in that short option, but it means risking even more than that.
Let me say it another way: Unlimited means UNLIMITED!
You cannot only lose what you have in the short options, but even more! So, you must educate yourself as to which strategies you can use for premium collection (hedged ones) and which premium collection strategies you cannot use (unhedged ones).
The Key to Writing Options
Now that I have given you your risk disclosure, I want to give you the key to successful premium collection. That key involves one of the option Greeks.
The Greeks are a group of statistical references that identify and quantify an option's sensitivity to different stimuli like movement in stock price, movement in implied volatility, and finally, the passage of time. The Greek that measures an option's time decay is called theta. It is the passage of time that is the key to premium collection.
Options are known as a "wasting asset" because they have a time limit identified by the expiration date.
Having a wasting asset means that each day you own an option, you lose a certain amount of money due to time decay. Moreover, every option has a different rate of time decay, or theta.
It is theta that is going to play an important part in choosing which strategy or specific option to use in a certain strategy.
Every day that goes by, an option loses money due to decay. Each day, this decay hurts us just a little bit more. It can get to the point that—if we wait too long for an option to perform—any gains we might make from the movement of the underlying security or implied volatility may be offset by the loss in value we had already accrued in time decay, as described for us by theta.
Additionally, it's very important for option traders to realize that, when talking about option prices, premium or price consists of two types of values.
The first of the values is intrinsic value, which is the amount by which an option is in-the-money.
We've talked about options that are in, at, or out of the money before, but for today's discussion, here is what you need to know when choosing which options to trade that best fit the strategy you're using.|pagebreak|
In-the-money options are the only options with intrinsic value, and intrinsic value does not decay.
The other value component of option premium price is extrinsic value and this element of value is all about time decay.
* An in-the-money option can have both intrinsic and extrinsic value at the same time.
* At-the-money options have just a little intrinsic and a lot of extrinsic value.
* Out-of-the-money options are all extrinsic value. It is extrinsic value that decays to zero over the period of the option.
If you are short an option or want to sell an option to try to take advantage of premium collection, you must understand theta. You need to know, and be aware of, which options are going to have the most amount of extrinsic value and which options are going to decay the fastest.
If you are collecting premium, you want to try to collect as much premium as feasible, and then have the value of the option decay as fast as possible.
What tells us those facts about an option? Theta tells us that.
But exactly how does theta tell us about how much and how quickly decay occurs?
If you have a theta of 0.024, for example, this means that the option's extrinsic value will decay 2.4 cents a day—every day while approaching expiration.
It is also very important to know that theta does not decay in a linear fashion. In other words, as the option approaches the 20-day mark until expiration, the rate of decay starts to accelerate.
For example, the 2.4 cents per day decay might move up to 4 cents per day, and the slope of the decay chart starts to "roll over" as with each day the rate of decay increases.
The extrinsic value starts to evaporate rapidly and reaches zero at the end of expiration day. That is, the option no longer has worth once it has expired.
Keep in mind that most out-month options (i.e., those that have expiration dates further out in the future) have little time decay until they start approaching the last two weeks or so before expiration.
This means that selling out-month options is not a good strategy for premium collection. You want to collect the premium and then have the option premium race to zero as fast as possible. So, sell the front-month if you are interested in premium collection.
The front-month option decays much more dramatically than an out-month option. So, if you're going to sell options to collect premium, make sure that you're selling the optimal option and that is always the front-month, at-the-money option.
Obviously, there is much to know about the premium collection theory and strategies. Considering the potential unlimited risks, it is critical that you learn and understand how to collect premium in the right, safe way.
By Ron Ianieri of Options University