Imagine getting paid to own a stock that you have a desire for—at the price you want?
By apply the right options strategy—it’s not only possible but a reality.
And it all starts with the core concept of: Selling options!
Today I want to run by the core concepts of options selling.
You’ll learn the difference between buying vs. selling, how the casino banks, and where time decay fits in.
Selling Options
Definition:
An option is a contract which gives the buyer (the owner or holder of the option) the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price prior to or on a specified date, depending on the form of the option.
With options, in general, the writer is referred to as the seller, and the holder is referred to as the buyer.
In exchange for selling an option, the writer of the option gets to collect a premium on the contract. A premium is a sum paid to the writer for a fee of writing the contract.
Another major benefit to options is the ability to “name your own price” if you are wanting to buy a stock at a discount.
And if the stock never reaches your price, you will get paid to wait for the option to expire worthless.
This is what selling options lets you do…
Buying vs selling options
In the markets, there are buyers and there are sellers.
Buyers are speculators who are hoping for huge price moves in the options they bought.
Sellers are option writers or sellers because they know that most of the options are going to expire worthless.
This allows sellers to keep most or all of the premium the majority of the time.
So essentially…
The sellers make consistent, predictable income for the options trader.
The buyer does not make a consistent or predictable income. Their account is full of losses with the odd big trade that keeps them coming back for more.
The best way to think of it is like a casino and the gambler.
We all want to run a business, so the trick is to find a way to become the casino.
Selling options you can: (Puts specific)
- Generate double-digit additional income and returns in any market condition.
- Add downside protection to your portfolio in the event of a market collapse.
- Get stock at exactly the price you want for a better way to buy the dip.
Like every tool, there is an appropriate time and place to sell put options, and other times where it is not an ideal strategy.
If used correctly, this is a sophisticated, yet simple strategy of entering into equity positions or collecting additional income to your trading revenue.
The problem with buying options
There are a few immediate issues a options buyer faces when purchasing options.
One major issue is having to deal with a number of factors that are going to cause the option price to decrease, such as, time decay and implied volatility.
So immediately once a buyer purchases an option, they are fighting an uphill battle to earn profits because you need to exceed the premium you paid to initiate the position.
So, you need to get the direction really right, in order to exceed your breakeven, combined with the timing to offset theta and the decrease of implied volatility.
Seeing as the stock market is like a casino, why bet on cards when you can be the casino itself.
The Casino
So we know the big picture. Now let’s see how we can put this to work for us since we now realize that buying options is a losing proposition.
This is primarily due to the premium you need to pay to establish a position.
So naturally, taking the opposite side of that bet is a winning proposition… just like a bookie or a casino would be doing to run their business.
Selling options is a lot like a casino where the house has a small, well-defined edge in their games.
Casinos understand that over the long-term, they will realize their expectations, and in the short-term, there may be losses and sometimes large ones.
In a casino, there are times where a high-roller will take them for a few million, but since their bottom has a steady stream of income, it is not a problem!
Perhaps it would make more sense to think of options as insurance sales instead of a casino, and an options writer is no different than an insurance firm.
By selling options you are underwriting risk for a premium just as insurance companies do for healthcare.
By looking at data and identifying that there is a positive expectation in selling options, it’s part of the business to pay a few larger claims while collecting on a majority.
Time Decay
Think of time decay as produce on a supermarket shelf. As time passes, the worse the produce is, until it’s expired.
So like produce, options have a limited life, and it’s value will diminish as it gets closer to the end of its life or expiration date.
Pros
Smooth Returns
- Selling options is one of the most predictable sources of returns in the markets.
- Premium selling strategies have a high win rate and are a great way to quickly grow a trading account.
Implied Volatility
- Implied Volatility is typically overstated on put options due to fear of a market collapse.
- Increased IV means higher option premiums in option contracts.
- To take advantage of this phenomenon, options sellers can sell options with elevated implied volatility levels.
Trading Psychology
- Many traders get defeated when taking a series of losses when learning how to trade
- Selling options give traders a high winning rate and percentage of trades.
- Increased confidence leads to less second-guessing and tweaking of models for no reason.
Cons
No Home Run Trades
- One major issue with selling options is that a trader will never have that “one big trade” opportunity to launch their firm to the next level.
- The knowledge that one big home run trade could be right around the corner keeps traders coming back for more every day.
- Selling options is similar to a mean reversion trading system with a high number of small wins.
Larger losses
- Selling options if left unchecked can leave significant losses.
- Selling options can have significant drawdowns that exceed the value of your trading account
- One of the most famous option seller to close their firm is the CTA group, optionsellers.com
Won’t Make You Rich
- Even though buying options have a trader bleeding money, the benefit of carrying an option on your books gives you the possibility of striking gold and becoming rich overnight.
- There are many cases where traders purchase OTM call options and get lucky.
- You have a max reward at all times. No option can go from $0.05 to $20.00 overnight giving you unlimited profits.
Wrapping up
Selling options is often referred to as “picking up pennies in front of a steam roller,” and this can sometimes be true, specifically in unfamiliar or changing market environments.
Unfortunately, there is no such thing as a free lunch when trading, and every trade comes with its pros and cons.
Of course, when trading options, short options can have significant advantages and some major drawbacks in other areas. One example of this is how Implied Volatility can change an option value without much else influencing the price in the underlying stock.
To summarize, premium selling is known to generate a smooth equity curve with an occasional larger loss.
Want to learn how to short options and how I went over 6 months without a single losing trade?
0 Comments