Would you like to Sell Options Premium with Limited Risk? How do you do that?
With the majority of options expiring worthless, many traders are interested in selling options. Options are a wasting asset. With no change in any of the underlying assumptions, an option will lose part of its value everyday until the option expires worthless. Time only moves in one direction, so an option seller benefits from the effects of time decay everyday. The option seller, however, must protect against a large adverse price move, as well as an increase in implied volatility.
Many traders start out selling premium
by shorting out of the money calls or puts, sometimes both at the same time. Statistically speaking, this is the most profitable strategy
. The reason for this is that the majority of out of the money options will expire worthless. The problem comes when the underlying market makes a large move in one direction and a trade may go against you. If you have traded too big the profit of months, if not years are erased. How do you sell option premium
and take small risk?
We will discuss two different types of spreads
in which the trader is net short premium. The first type of spread will be a defined or limited risk spread and the second type will be a spread with unlimited risk. There are different ways to structure both types of spreads
. We will offer some different ideas that the trader can build on. As a note, many traders are frightened by the term “unlimited risk”. But keep in mind, any outright futures trade has unlimited risk with a 50% chance of profitability. Many unlimited risk option spreads have far better statistical odds of profitability with the same or even lower risk.
Defined or Limited Risk Spreads
Call spreads, put spreads and some calendar spreads are defined risk trades. In stock options trading, calendar spreads always have a defined risk.
By selling call spreads, put spreads or both, the trader ends up with a net credit in their account. If the short leg of a credit spread expires worthless, the trade is profitable.
Usually we don’t adjust spreads. The risk risk you took is no more than the width of your strikes. So, when you position size is small you just leave the trade on.
Unlimited Risk Spreads
The unlimited risk spreads we will briefly cover in this article are vertical ratio spreads. To sell these spreads at a credit, the trader would buy the close to the money option and sell at least twice as many further out of the money options.
Typically you have to manage the trade when the position is too far in the money.