Collecting Option Premium
When you sell options you receive option premium. There are many different strategies for collecting option premium. It may sound dangerous to sell options but these strategies contains less risk than you would think. You can sell Option Premium in rising, falling or even in flat markets. Basically you sell options and collect option premium in any market condition.
Rather than trying to trade options within a range, more and more traders are turning to premium selling. With selling option premium you will take advantage of a drop in volatility and Time Decay. Selling option premium is easy to understand when you know the two basic strategies very well. We will discuss these two strategies below. It is about collecting option premium: selling naked options and selling option spreads.
Strategy 1: Selling Naked Options
Professional option traders will tell you that option selling is preferred over option buying. You have a much higher chance of success to profit due to time decay. The most basic strategy in selling option premium is the naked sale. This involves selling either a call option or a put option.
A trader will sell call options if he is bearish and thinks that the market will go down. He will sell a put option if he is bullish and thinks the market will rise. If you believe the market will stay flat may sell both puts and calls. There are two types:
1. Sell a Strangle that is selling both an out of the money put and a call option
2. Sell a Straddle that is sell both an at the money put and at the money call option
With options you have to put up less capital then buying options. With both of these types, risk is virtually unlimited, while rewards are limited. In everyday life a stock seldom changes 20%, so it is unlikely that the price of the option goes through the roof. A trader can make only as much as the premium collected, but is accountable for the entire move past the given strike.
Strategy 2: Option Spread
Another strategy to collect option premium is to sell option spreads. To limit the risk which comes with selling a naked option sale, a trader might choose to use an option spread instead. This is a strategy where a trader sells an option and the purchase of another. In this way he will hedge the risk of the option he sold. Another advantage is that if you are not allowed to trade a naked put in your IRA account, this strategy is permissible.
For example, In August Apple was rising to 102. A trader who believes that AAPL will move higher choose to sell a put option with at $1.40 and 100 strike price. He decides to purchase a put option with a 96 strike for $0.70 for protection. This kind of trade is called a put spread. The put spread was sold for 70 cents. The maximum profit on this trade would occur if the option expires with a price of Apple is higher than $100. The maximum risk is the difference between the two strikes minus the premium collected (100-96)-0,7= 3.30 of total risk.
An opposite position can also be taken. For example, another trader who is bearish for the stock AAPL will sell a 100 call option and will buy a 102 call option as protection. The spread will be sold for $1.32. The maximum profit will be achieved if the options will be sold when the price is under 100. The maximum loss will be achieved if the option expires above 102, at which point the loss will be the difference in the two strikes minus the premium collected ($2 – $1.32 = $0.68 of total risk). In the following paragraph we have a video about collecting option premium.
Video on Collecting Option Premium
The price of an option comprises at intrinsic value and time value. Click on the picture and watch the video how this is related to collecting option premium.
Do you want to learn how maximise your profit? Continue to read our article about Managing Winners