Options The Cash C.O.W. (Conservative Option Writing)

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.

Quick Refresher
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.

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.
 
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In this article, the author provides a solid overview of how one can profit from being a seller of options.
 
This article does nothing of the sort.
It is misleading in the extreme.

And in point of fact, is potentially so dangerous, it should be removed.
 
The article is good. Selling options is a good game giving you some income month after month. and income upfront as well.

I wish the article had covered more on selling options on indexes and on on futures .
 
I completely agree with Ducati, the article is rubbish and misleading. At best it's an incomplete story as according to classic option pricing models writers edge does not exist.

Off course it's perfecly ok to have an opinion that differs from mainstream opinion and theory. In an educational story imho it should be clearly stated if an opinion is highly controversial.

The article lures people with little knowledge into an extremely high risk strategy without the appropriate warnings that should accompany such an advise.
 
In the Knowledge Lab there are some very good articles written by people who do seem to want to spread knowledge, then there are artilces written by people who seem to want to spread sales leads.

One can normally tell which it is by the quality of the article and looking at the authors web site (if any).
 
ducati998 and silent.trader

May I ask both of you-Have you ever sold options or your opinion is just based on some theory?

I am not boasting but I have sold options for last 20 years. Initially I was only selling covered call options on UK shares . Commission was high with UK brokers,so I moved to IB

I sell options on indexes and on futures. In last one year there has not been a single assignment and I have not closed any loss making positions. Return on my capital employed for last year has been about 30%
 
osho67,

I understand the years 2000 and 2002 would not have been good for option writing strategies. Has that been your experience too?
 
Osho, I mainly sell options, and I really like to do so. The results vary off course. Last year I made nearly 150%, this year up till now I'm up only a couple of percent. Option selling may give the feeling of having an edge, I strongly doubt that, in the long run, this edge really exists as the very rare huge move may wipe out the gains of many winning trades. At least in theory the edge does not exists.

Combined with proper predictions of the market selling options is a winning strategy, but the same goes of course for the long options strategies. The big difference between long and short options strategies is imho the way you have to predict the market to be profitable. In a way this is also said in the article. The advise is to sell options near support and resistence levels. Implied in this statement is that straightforward selling of options has no edge. Nevertheless he write's "It should be obvious by now that selling options provides traders with an advantage over buyers". Apart from the fact that this statement is not backed up by theory, it does not even follow logically from the text before the statement.
 
Silent.Trader said:
. . . this edge really exists as the very rare huge move may wipe out the gains of many winning trades . . .

Huge moves are statistically quite common.

I guess you wern't employing this stratagy in 87?

With no mention of the "Greeks" this artical is at best disengenuous and falls far short of this boards' normal standard.
 
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Tuffy

I have not found any bad year as I only sell options for the near month and go deep in the money as much as possible. To give an example, yesterday I sold put on YM 9700, expiry June.
 
osho ... is that deep in the money or out of the money?

Its a while since I played with options but that sounds to me like deep out of the money.
 
kivi

yes i am confused as well. ym is say 10550 and i have sild put at 9700. where am i?
 
osho,

So if the market does not fall over 8% by the expiry in June you walk away with a profit. If I had bought your put I think I'd be out of the money (no intrinsic value)....not sure what the jargon is for the seller.

I mentioned the poor years ealier after reading through the results of the LJM Fund who I think just concentrate on this strategy. You can see from their historic results that such a strategy is not without it's hic-cups!!

www.ljmfund.com

Whilst most of the time the money comes in OK the market does have a sting in the tail now and then.
 
osho67,

May I ask both of you-Have you ever sold options or your opinion is just based on some theory?

If you go to my General Motors thread and trade, you will see that I sold covered calls, some $7.00 OUT OF THE MONEY, guess what, I got called.

Now, as they were covered calls, my RISK was properly accounted for.
The article, however, is advocating the selling of NAKED CALLS & PUTS.
This is a very different strategy than mine.

Your risk, is in theory unlimited.
Management of that risk involves, closing for a loss, or rolling over.
None of this is really clarified.

If KNOWLEDE LAB, are going to post specific strategies, they should;
1......Highlight the risks
2.....Show how those risks are, or should be managed.

I am not boasting but I have sold options for last 20 years. Initially I was only selling covered call options on UK shares

If you have been selling premium for 20yrs, why did you not highlight the ommissions in the article?

I sell options on indexes and on futures. In last one year there has not been a single assignment and I have not closed any loss making positions. Return on my capital employed for last year has been about 30%

A typical novice mindset.
Any strategy that is successful will return money.

The professional will state always the converse, how much could I lose, if this fails.

From the article;

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.

The direct implication is that writing naked premium, is SIMILAR to the writing of Insurance premium.

That is to say, the Actuarial tables used to calculate mortality rates, or fire hazard rates and provide well established probabilities, are somehow SIMILAR to Technical Analysis providing probability of market direction, thus providing the user with a strategy based on a mathematical calculation of probability.

This is quite absurd.

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.

Here it is.
This is the discussion on risk and his discussion on risk management.
Is this adequate?
Who is likely to read this and think, hmmmmm, easy money.
Professional or Novice?

It goes on, just more of the same.
He has taken quite a good strategy, and made it look like a great strategy, without covering the risks and management of those risks.

Who is responsible?
Is it the author? I would say he does carry responsibility, as he penned this woefull piece.
However, T2W, also carry responsibility for posting this.

They have placed it under their KNOWLEDGE LAB banner, and as such have given to believe to anyone reading the article that they ( T2W ) have read it, edited it if necessary, to ammend any oversights, ommissions, and that it conforms with their mission statement, to provide education and reference material for novice traders.

What they have signed off on, NAKED OPTION WRITING, is potentially one of the most dangerous strategies to a novice trader there is. It is a DERIVATIVE.
Derivatives, without expert knowledge are a potential bomb.
This article in no way, shape, or form even approaches the level of knowledge required to trade this strategy.

cheers d998
 
Thanks ducati998

I very much appreciate what you have said and time you have taken to write at length.

May I ask for some advise? I sell naked puts on Z,YM,ER2,DAX,ES but they are all corelated. Are there some other instruments to sell which will not be corelated. Thanks for your views. Learning is never complete.
 
Most people do not have the margin to write options,and simply get blown up. You need a seriously big pot-same as being a bookie-I know i've been doing it long enough!
 
osho67 said:
Thanks ducati998

I very much appreciate what you have said and time you have taken to write at length.

May I ask for some advise? I sell naked puts on Z,YM,ER2,DAX,ES but they are all corelated. Are there some other instruments to sell which will not be corelated. Thanks for your views. Learning is never complete.

In my opinion virtually everything is correlated in the financial markets. Perhaps correlation seems to be low, at the moment serious turmoil occurs correlations are completely different from what was expected based on historical data. This specially applies to the several stockmarkets.

A reasonable diversification may be to operate in stock markets, currency markets and commodity markets. The best diversification for put selling is of course call selling.
 
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