Imagine how much money you could have made had you sold every option that you have ever purchased? While many traders boast of huge profits attained from a singe long option play, these stories are rare in comparison to those in which traders have lost some, or all, of the premium paid for an option.
In a sense, option buyers are throwing good money after bad in hunt of that one big market move that could return extraordinary profits. Given the fact that markets spend most of their time trading in a range, it is easy to see why few traders experience the abnormal returns that drew them to the markets in the first place.
A less exciting, but more fundamentally sound approach would be to attempt to profit from markets that are trading in a range. The most efficient means of taking advantage of a ?quiet? market is to strangle the current range by selling calls above technical resistance and puts beneath support levels.
The logic of a short option strategy, such as a strangle, is similar to that of insurance companies. Insurers collect premium on policies with the expectation of future payouts. By knowing the probability of a claim, they can calculate their expected return for assuming the risk of the policyholder. They are confident that over time they will profit despite their obligation to pay claims.
By nature, options are a depreciating asset. Just as a new car buyer will find that the value of their purchase diminishes once the automobile is driven off of the seller?s lot, an option buyer will find that the time value of their long option erodes with every passing minute.
It should be obvious by now that selling options provides traders with an advantage over buyers. After all, a seller of a call option can profit in a declining market environment as well as a market that is trading sideways. In fact, it is possible for a seller of a call to also profit during times of increasing prices given that the market does so at a slow enough pace. A buyer can only profit on a call option if a market rallies over a specific price in a specific time limit.
Nonetheless, traders continue to be lured into long option strategies. This is likely due to the fact that purchasing an option provides traders with unlimited profit potential and the risk is limited to the premium paid. The peril in this type of approach, as mentioned before, lies in the fact that although one?s losses are limited it is likely that an option buyer will lose some or all of the value of the option.
The exposure to unlimited losses by option writers is merely theoretical. In theory a market could go up forever, but it isn?t likely. Additionally, while most markets can?t go to zero (equities excluded), they can drop significantly. However, due to the leverage and risk involved it is imperative to have adjustment strategies in place before a position is executed.
An option premium is the actual market price of a particular option at a particular time. Thus it is necessary to understand the fundamentals to option pricing before implementing a short option strategy. The exact price that buyers and sellers are willing to accept at any given time is based on two major factors, intrinsic and extrinsic value.
Simply put, intrinsic value refers to whether or not an option is in the money and to what degree. For example, the intrinsic value of a call is the amount of premium by which the underlying market price is above the strike price (also known as exercise price). Accordingly, a put option is said to have intrinsic value once the market price dips below the strike price. An option with intrinsic value is ideal for an option holder, but creates an undesirable situation for an option writer. If a short option expires in the money, the writer will be assigned a corresponding position in the underlying market. In the case of a short call, the seller will be short the underlying from the stated strike price. Conversely, a trader with a short put will be assigned a long position from the strike price. It is often in the best interest of the option writer to offset a position prior to expiration in the case of an in the money option.
The extrinsic value of an option is a combination of several factors including the strike price relative to the underlying price, market volatility, time to expiration, and demand for that particular option. The goal of an option seller is to profit from the erosion of intrinsic value. Times of increased volatility provide ideal circumstances for option sellers because option premiums are inflated. Similarly, it is helpful to understand that the depreciation of extrinsic value tends to accelerate during the last 30 of an option?s life creating an ideal scenario for option selling.
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.
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.