Long before weekly options were a thing when ticks were still in 16ths, and we downloaded batches of chart data over a dial-up modem…I “discovered” the world of options, states Chris Vermeulen of TheTechTraders.
Like most options newcomers, I first learned about buying options—either Calls or Puts—to hopefully profit in a directional move of the underlying stock. I’d buy Calls to profit from an increase in the underlying’s price and Puts to profit from a decrease in the underlying’s price. Simple, yes? (Okay, maybe there’s a bit more to it than that.)
Soon after, I learned about selling options—about how I could “outsmart” the market by being a seller of options rather than a buyer. Ah, those were the days—of option-selling thrills and sudden “learning experiences.”
To Buy or Sell Options
Option selling strategies can work well if your objective is steady, repeatable income. Selling options rather than buying does have its advantages. As theta time decay works in favor of the option seller, premium sellers tend to have a higher probability of a profit. The tradeoff is that the profit is limited to the amount of net option premium collected.
Selling options—Puts or Calls—also comes with a potential obligation to either provide or buy the stock at the option strike price. Those obligations could present substantial risk depending on the underlying stock, implied volatility, position size, and how the trade is structured.
Being the “smart” young trader I was, I soon realized I could look for stocks with very high option premiums and focus on selling those. My trading platform even made it easy to create scans based on high implied volatility to find them.
It’s not hard to find extreme option premiums on small stocks. Quite often, there is a pending big news event. For example, a small pharmaceutical company with its only product in trials and has FDA approval pending. In a situation like that, where the company’s whole future could ride on approval news, we’re likely to find astronomical option premiums. Don’t be tempted.
What could possibly go wrong? If the approval falls through for some reason, the entire company could be out of business in short order. And option sellers can be left “holding the bag.” It happens.
There are no giveaways in the options market. When premiums are high, they are high for a reason. When we buy options, we have risk up to the amount of premium paid. When we sell options, we could have a much greater risk of buying soon-to-be-worthless shares at the strike price.
Tips for Selling Option Premium
Avoid Illiquid Product
If you see a stock with very thinly traded options, take it as a warning sign. If you want steady, consistent results, stick with larger, more well-known stocks with good liquidity. I regularly look at S&P 500 and Nasdaq 100 stocks for candidates. That’s an excellent place to start when looking for premium-selling opportunities. Stocks with weekly options, and reasonable participation in those options, tend to be better candidates.
When there’s good liquidity in the options, you’ll see decent volume and open interest across a range of strike prices and expiration dates. These options should have narrow bid/ask spreads, sometimes as little as a penny wide. You can get in and out of trades or extend duration by rolling at fair prices.
When the bid/ask spreads are extremely wide, it could be just you vs the option Market Maker. Option Market Makers are the buyers/sellers of last resort. Market Makers generally hedge their directional risk as their core business is to make money not from directional moves but rather from the bid/ask spreads. So, if it’s just you and the Market Maker trying to agree on a price, don’t expect any mercy. Market Makers have kids to get through college too.
Avoid Extreme Premiums
Learn to recognize when premiums are extreme. The implied volatility will be high versus the historical volatility. When premiums look too good to be true, look closer. There is always a reason.
This is not to say you can’t sell expensive option premiums.
But, for example, don’t sell Puts on more stock than you’re willing to own, even if the stock goes to $0.
Five Rules for Option Sellers
- Adopt a long-term mindset. We want our option selling strategies to be repeatable and sustainable so that we can stay profitably “in the business” for the long term.
- Don’t sell premiums on the hottest stocks you can find just because the premiums are huge and tempting.
- On any trade, mind your position size. If the stock makes an outsized move or even goes to $0, will you be able to shrug off the loss? Size accordingly.
- Always understand your worst-case risk. Stock prices can do things that we thought were very unlikely when we opened the trade.
- Trade liquid products. I can’t emphasize enough how important it can be to get fair prices when buying, selling, or rolling. We don’t want to start our trades with the distinct disadvantage of not being able to get “fair” prices.