Playing the Odds—Selling Premium

07/07/2014 8:00 am EST

Focus: OPTIONS

Bob Lang

Founder and Chief Analyst, Explosive Options

Bob Lang of ExplosiveOptions.net exposes the way to get even odds in trading options.

I’m sure most of you know that the house in a casino mostly has odds just better than 50% in many table or dice games.  So, how would you like to have even better odds than the house?  It can be done!

I bet you didn’t know that 80% of all options expire worthless.  So, if you are a seller of option premium then you’re looking at a four in five chance of being right out to expiration.  Of course, are you willing to hold on that long?  And, will market volatility stay down and let time decay ‘be your friend’?  Further, do you have the capital resources to post required margin?  Lots to think about.

I don’t advocate selling naked options except under the most perfect conditions, which is a declining or static volatility environment.  Why is this?  We want to be net sellers when premiums are getting cheaper not pricier.  We want time to work in our favor not against us, the decay best when stock prices range and the odds of future expectation of big moves is high.  Basically, we want a benign market landscape.  But the market is uncertain, attitudes change and sentiment is elastic.  Well, it’s not a game of perfect but we put the odds in our favor—knowing what we could expect the outcome to be.

Options are a zero sum game with a kicker.  There is a winner and a loser, yet since options are a wasting asset there is the time decay to consider and with swiftness of the stock move.  We also must consider the velocity and acceleration of the move—do we want to be in an option that move 10% in five days or five weeks?  I prefer the former when I’m a buyer, the latter when I’m a seller.

When I sell option premium it’s usually to finance other trades—I’ll take in the cash from the sale to make other purchases.  So, I’m more than likely awaiting the outcome of my short sale (calls or puts) while using the cash.  We can basically get a double working but of course it can backfire.  Just this past Spring, I’m short puts many commodity names—well, we know how that hurt.  But if you told me the VIX would be stagnant I would have said my short puts would have fallen.  That certainly wasn’t the case and I was forced to either buy back the puts at higher prices or roll them out to longer months.  I did the latter and it has worked out so far, but that wasn’t the plan.  I had to call an audible—remember, we have ‘options’ and choices.

Why is it not advantageous to sell premium in a rising volatility environment?  Ask anyone who was short puts in late 2008/early 2009.  I knew colleagues who were blasted from selling far out of the money puts as the short strikes were attacked—this when the VIX was rising to nearly 100.  Selling calls?  Sure, a great strategy in this type of market yet the premiums are already juiced and you won’t get much bang for the buck—you couldn’t stay in the position long enough to make the return worth your while (or worth the risk).   I will rarely if ever sell naked calls but certainly selling puts is a great strategy.  Covering yourself by buying a strike further down the chain alleviates some risk but also cuts back on your total return.

By Bob Lang of ExplosiveOptions.net

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