T2W Trading Community

Know the Market Climate
Before executing short option trades, it is imperative that traders analyze the “climate” of the market.  The three primary aspects of a market that should be considered are volatility, liquidity and technical indicators. 

Perhaps the most important factor to be considered is the liquidity of the market.  With the possibility of unlimited risk, traders must be able to easily liquidate an unfavorable position.  Options in thinly traded markets tend to have relatively wide bid/ask spreads, which will exaggerate losses and reduce profits.  Markets that offer traders ample amounts of liquidity include: stock indices such as the S&P 500 and fixed income such as US Treasuries. 

Volatility is an important component of extrinsic value. Thus, during times of increased market volatility option premium tends to be inflated.  This provides an advantage to sellers.  Volatility can be determined by looking at indicators such as historic or implied volatility available on most charting software or by simply looking at a price chart. 

Check the Conditions
Once a market is deemed to be suitable for option selling, a trader should scrutinize the technical condition in order to determine appropriate contract months and strike prices. Trading ranges as well as support and resistance levels should play a big part in short option placement.

Traders should obviously sell call options above significant technical resistance and sell puts below known support levels. Even if a market succeeds in penetrating known support and resistance, it will likely stall before doing so.  To a short option trader, time is money. As mentioned before, every minute that passes diminishes the time value of an option.

Depending on market conditions, it may not be appropriate to write strangles.  The purpose of selling options is to increase the probability of success, thus picking tops and bottoms are counterproductive. If a market is entrenched in a definitive uptrend, it doesn’t make sense to sell calls. Doing so will likely lead to an unfavorable scenario. On the other hand, selling puts is extremely attractive.  Even if the market does reverse and go against the short put position it probably won’t do so immediately.  Remember, as time goes by, the extrinsic value of an options erodes, providing profits to the seller and losses to the buyer of an option. 

Too many short option traders focus on their strike price relative to the underlying market price, when in reality they should pay more attention to the intrinsic break-even point of the trade.  Although it becomes an uncomfortable position, options that are in-the-money experience accelerated time value erosion. As long as the market stays within the intrinsic break even it will be a profitable trade at expiration.  Patience, combined with humbleness, is a virtue in short option trading.  Even markets that are trending do not go straight up or down providing opportunities for exiting uncomfortable short option positions.  Traders will find that liquidation out of panic is often not the best remedy to the situation.
 
Final Thoughts
As with any trading method or system, losing trades are inevitable when trading short option strategies. Thus it is important however to point out that there is substantial risk involved.  Many option sellers fall victim to greed. Failure to cut losses short can put traders at the mercy of the market.  While the odds of a profitable trade are in the favor of a premium seller, unlimited losses leave the seller extremely vulnerable. For this reason, adjustments and trading plans are crucial to maximizing the results and minimizing losses.