The ABC of selling Options
Learn the ABC of selling options. Investors who trade options has to make many decisions like buying or selling options. Which strategy is best considering the market. What is investors assumption about the stock. If an investor is bullish, she can sell a put, whereas if she is bearish, may sell a call. There are many reasons to choose each of the various strategies, but it is often said that “options are made to be sold.”
This article will explain why options tend to favour the options seller, how to get a sense of the probability of success in selling an option and what risks accompany selling options.
Advantage of Selling Options
The phrase “time is on my side” is not just popular because of The Rolling Stones. It is also because selling options is a positive theta trade. Positive theta means that the time value in stocks will actually melt in your favour. You may know that an option is made up of intrinsic and extrinsic value. The intrinsic value relies on the stock’s movement and acts almost like home equity. If the option is deeper in the money (ITM), then it has more intrinsic value. If the option moves out of the money (OTM), then the extrinsic value will grow. Extrinsic value is also commonly known as time value.
A buyer of option expects the stock to move in one direction and hopes to profit from it. However, this person pays both intrinsic and extrinsic value. He must make up the extrinsic value to profit. Because theta is negative, the option buyer can lose money if the stock stays still. More frustrating is when the stock moves slowly in the correct direction but the move is offset by time decay. Time decay works so well in the favour of the option seller because not only will it decay a little each day. It’s a slow-moving money maker for patient investors. For this reason we like to sell options so that we collect option premium and that time decay is on our side.
Volatility Risks and Rewards
When we talk about the ABC of selling options you need to know about volatility and risk and rewards. You enter a trade with an assumption. Obviously you hope that he stock price moves accordingly you expectations. But paying attention to Implied Volatility changes is also vital to your success. Implied volatility moves up or down depending on the fear in the market.
In most cases, the inflation will occur in anticipation of an earnings announcement. And the day after IV will goes down. This knowledge of Implied Volatility provides an edge. The option seller is selling premium when it’s high. And he buys it back when the option premium revert to the mean.
At the same time, time decay will work in favour of the seller too. The closer the strike price is to the stock price, the more sensitive the option will be to changes in implied volatility. Therefore, the further out of the money a contract is the less sensitive it will be to implied volatility changes. It’s very important to understand this.
Probability of Success
Option buyers use a contract’s delta to determine how much the option contract will increase in value if the underlying stock moves. However, option sellers use delta to determine the probability of success.
When an option has a delta of .50 it means that it moves 50 cents when the underlying stock moves $1. An option seller would say that a delta of 1.0 means you have a 100% probability of success that the option will be at least 1 cent in the money by expiration. On option with a .50 delta has a 50% chance that the option will be 1 cent in the money by expiration. The further out of the money an option is, the higher the probability of success is. Of course you will receive a smaller option premium when you are further out of the money.
Figure 2: Probability of expiring and delta comparison
At some point, option sellers have to determine how important the probability of success is compared to how much premium they are going to get from selling the option. Figure 2 shows the bid and ask prices for some option contracts. Notice the lower the delta that accompanies the strike prices, the lower the premium payouts. This means that an edge of some kind needs to be determined.
Manage early to lock in profits
Many investors refuse to sell options because they fear worst-case scenarios. The likelihood of these types of events taking place may be very small, but it is still important to know they exist.
First off selling a put option has the theoretical risk of the stock going to zero. This seems to be unlikely, but we want to mention it though. To eliminate the risk you can sell a put spread instead of a naked put.
Secondly, selling a call option has the theoretical risk of the stock climbing to the moon. While this may be unlikely, there isn’t an upside protection to stop the loss if the stock rallies higher. Therefore, call sellers need to determine a point at which they will choose to buy back an option contract if the stock rallies.
Selling options may not have the kind of excitement as buying options, nor will it likely be a “home run” strategy. In fact, it’s more akin to hitting single after single. Just remember that enough singles will still get you around the bases and the score counts the same.
In this article we talked about the ABC of selling Options. We have discovered that you benefit more when you sell options. Options with high implied volatility are rich in option premium. The options become less value because they are prone to time decay.
To get a higher number of success, traders manage the options early by buying them back for a lower price. They can re deploy their capital for new trades. Read also our article tips for beginning traders