How to Collect Cash Using Options Prior to Expiration
01/14/2011 3:03 am EST
Let’s delve a bit into one of the more advanced options concepts—selling time premium. Newer traders will need to educate themselves on terms such as Theta and Delta prior to implementing this concept.
Traders who are new to options often begin with just call/put purchasing and perhaps covered calls. Then they begin to wonder what the other side of the options transaction is like. Remember that for every single listed option trade, there is a buyer and a seller. Usually, it’s the public buying options and the market makers handling the order flow and maintaining an orderly, two-sided market.
Right now, one to two weeks to go before monthly options expiration (the new weekly options are a whole ‘nother story) is often a very attractive time to sell option premium due to the rapid decay that will occur by next Friday’s close. First, I’m generally not a fan of ever selling “naked” options (not covered by another option or underlying)…unless perhaps you run a giant hedge fund.
Your risk can be unlimited, the margins are very high, and you can have ten winners in a row and one big loser can wipe out all your profits and more. So one of my preferred ways to garner that rapid decay in time premium (Theta) is to sell front-month, out-of-the-money call or put spreads ahead of expiration. This is known as a credit spread, or also a vertical call or put spread, and it’s a great way to collect cash using options.
The “spread” part means that we are selling one option and buying another in the same amount, in one simultaneous transaction, and receive a net “credit” (cash) for the trade. So if you are looking at doing this, you need to find a stock/index/ETF that will either go your direction or be flat heading into expiration. The nice thing about these credit spreads is that you get a “cushion” within which the security can move against you and you can still make the maximum profit on it.
Let’s look at some examples with real-time prices using the S&P 500 Index ETF (SPY), which basically mimics one-tenth the performance of the SPX index. Let’s assume you are bullish or neutral on the Spyders heading into next Friday’s final trading day for January options, the 21st. SPY is currently at 128.50.
The SPY has one-point increments on its strike prices and is very liquid with small bid/ask spreads, so securities like this are particularly attractive ones to sell premium on—you don’t give up as much “edge” to the market makers with wide big/ask spreads and execution problems. And while the SPY itself is fairly high-priced for a stock, being above 100, the implied volatility on its January options really isn’t that high. The at-the-money (ATM) straddle is currently only trading around 13% implied volatility. So with our bullish/neutral theoretical stance (not a trade recommendation), we would be looking at January out-of-the-money (OTM) put spreads to sell.
If one is banking that the SPX itself will go out above the key 1,250 level next week, we could look at selling the SPY Jan 125/124 put spread. At the time of writing this article, the spread is 0.07 by 0.11. The max risk is the premium received minus the difference between the strikes, so in this case, if we sold it at eight cents, the max risk is 92 cents. That’s an 8.7% return on risk in 1.5 weeks, also with a price cushion of approximately 3.6 points on the SPY to breakeven level of 125 (around 2.8% downside protection). That return is a bit lower than I usually prefer for my front-month credit spreads (I prefer 15% to 60% max potential gains), but since 125 is such a key technical/psychological level, let’s just use this as a theoretical example.
Basically in this case, if we sold this one-point spread for 0.08 ($8), then $92 is required for each spread by most brokers as the margin required (maximum risk). If the stock goes out above 125 next Friday, the two options expire worthless and you keep the $8 credit received for a quick gain.
You also have that cushion whereby the SPY can go almost 3% against you and you’ll still profit. That’s why credit spreads in this manner have a high probability of success—so you don’t have to be correct in your directional pick, you just can’t be dead wrong. Your own personal risk/reward comfort level should help determine what spreads you feel most comfortable selling.
When selling premium, it’s natural to begin by collecting more cash for options sold than you pay for options bought. And those who sell naked options never think about buying protection or limiting losses because it cannot be done for free. The following discussion of this specific trader mindset refers to trading spreads rather than naked options, although the principles are the same.
The opening trade is easy. The trader wants to collect a cash premium and choose one of a bunch of strategies that enable him/her to do that.
NEXT: The Hard Part Is Knowing How to Manage the Trade|pagebreak|
Managing the Trade
This part is more difficult. If all goes well and time passes, then the option values decrease and may eventually reach a point that you are willing to spend a small sum to exit the trade. However, it’s likely that the position will be held, hoping all options expire worthless. Paying a few nickels to exit a trade and eliminate all future risk is not a popular idea.
One of the problems with this mindset occurs when the market does not behave in a manner that is friendly towards our trader’s position. Premium selling and negative gamma are close relatives. When the market goes against a position, further moves increase the rate at which losses increase, and the position becomes more dangerous.
Traders with a more normal mindset of “This position requires an adjustment because my current risk is too high and I must avoid a large loss,” have no trouble making good trades that reduce risk. Most of the time, these trades involve spending cash.
- Reduce size and buy back some of the position
- Buy single options for protection
- Buy debit spreads for protection
The strategy tends to be to buy something and spend cash.
However, the trader with the mindset under discussion of “I don’t want to pay cash for any option trades. I do want to prevent large losses, but I will find a way to protect myself with no cash out of pocket” has a more difficult time managing the trade.
Clarification: It may not seem to be a more difficult time for the trader. He/she is happy to sell extra premium because it affords an opportunity to make even more money. However, these traders increase overall risk and do almost nothing to take care of the current problem of having more risk on than they can handle.
When the market rallies and the position is short too much Delta, this trader does recognize the need for making an adjustment. At those times, the most obvious first choice (for the “take-in-cash’ traders) is to sell some puts. That not only adds cash to the coffers, but it adds positive Delta. That’s a feel-good trade, however, it’s very shortsighted.
What’s wrong with getting some useful positive deltas by selling puts? Two things. First, it does almost nothing to reduce the current upside risk. The only upside benefit is to keep most or all of the put premium collected. However, that cash is not enough to offset the losses that accrue as the market marches higher and negative gamma soon makes the position lose money more quickly than it did before the adjustment. Second, the position now has risk where none existed—downside risk. And for what? For the cash collected to “protect” the upside. Selling those puts is not a good idea.
Using this strategy is a good way to collect some cash with limited risk and add a few dollars to your trading account.
By Price Headley of BigTrends.com