Here is a good article written by Craig Harris, whose newletter I have followed for many years, regarding writing vs paying premium.
Part II..."selling options is similar to being in the insurance business."
I hope everyone tries to understand what I've written here below. This is the culmination of 20 years or so of thinking about options, and it's information you probably won't find anywhere else.
so, last night I covered the basics. To recap, when you buy an option your risk is limited and your profit is unlimited. When you sell an option your profit is limited and your risk is unlimited.
Now lets take a look at some statistics. According to Donald Moine, Ph.D., as well as many other similar studies, 90 percent of all options expire worthless. So, with just that statistic alone, you can see that nine out of ten times, the long option holder will have an option whose final value is zero...he will lose his entire investment. In many cases the option holder is still quite happy because he bought insurance and didn't need it.
Now...here's the other important fact. When you buy an option, you buy time. For an out of the money option, there is no intrinsic value. The price you pay for the option is for the time value of the option. For every day that goes by, the price of the option decays according to the theta parameter. If you sell an option, time is on your side. As time passes by, the theta decay is in your favor. This is an important concept. Options have time value...when you buy an option time works against you...when you sell an option time works for you.
So, why do I say that "selling options is similar to being in the insurance business." Lets take a look at an insurer. You pay a premium to the insurer. The Insurer absorbs the risk that something bad will happen, and if it does he pays you off. The insurer does his math so that the statistics behind the insurance say that he will take in more premium than he will pay out in losses.
Now, if you sell (short) an option, you are taking on a lot of risk for a small profit. You hope that nothing bad will happen. If the option expires worthless you keep the premium and pay out nothing, and if it expires in the money you in effect pay off the option buyer. You are acting in the same capacity as an insurer.
To the contrary, when you buy an option, you could be hedging your risk...buying insurance, or...you essentially have a lottery ticket. You paid a fixed amount for the ticket, and there is some remote probability that it will pay off big. The question for you is...what's the payout? I've said in the option's market it's 10%. But...here's the thing. Even with a 1 in 10 chance, you also have to consider the size of the payout....if it's large enough you could still lose money 9 out of 10 times and make a net profit. So, that's the profile of the long option...lots of losers balanced against a few big winners. It's the opposite for selling...lots of small winners with a few big losers. What I'm saying here is that I do think you could be successful as an option buyer...but in order to do that you would have to very keenly spot and trade only the winners....and the big question is whether or not your ability to pick winners over the long term skews your probability of winning and your potential payout enough to be a long term winner. The statistics say that for most people, they can't. I want to use strategies where I don't have to buck the odds to be a winner because I am not under the delusion that I am that much smarter than all the other market participants.
The big question is this....as I said above, the insurer makes sure that the total premium he charges more than offsets the payout risk. In other words, the insurer has to be sure that over the long run he takes in more than he pays out (or else it's government bailout time). So...with the statistic that 9 out of 10 options that you write (sell) will expire worthless, the statistic you now have to worry about is premium....you need to make sure that the premium taken in covers the 1 in 10 chance that you will have to pay out.
Here's what I do though to make it even more attractive to me.
1.) I don't just randomly sell options.
2.) when selling options, my favorite and most commonly used strategy is to sell out of the money puts on things I want to buy anyway at lower levels. I first read about that strategy while reading an interview with some stock trader in Barrons on an airplane just after college and the idea immediately struck me as something I could apply from stocks to the futures markets. Even better...the strategy is more dangerous in stocks because stocks go out of business...and futures don't so I wanted to leverage that aspect into my trading rules as well. In other words. lets say I like wheat. Lets say the price is currently 330...just a little steep for me to be a willing buyer, but at the same time I'm thinking, I'd sure like to be long wheat if it was 3.00. So...what if I could sell the 310 put for 10 cents? If I could, then my cost basis if I needed to take the long assignment (the payout) would be (310-10=300) and if I didn't need to pay out then I just keep my premium. So...the beauty of this strategy is that you take the 1 in 10 risk and turn it into a positive. In other words, 9 times out of 10 I'll keep the 10 cents. The one time, I'll take the long assignment because I'm bullish on wheat at lower prices and I'd be a buyer there anyway....and wheat isn't going out of business.
But wait....it gets better. Buy now and get a free pocket calendar...just kidding...Sometimes...the futures markets go into backwardation. In other words the front month futures are more expensive than the deferred month futures. But guess what? The deferred month options are priced off of deferred month futures. So, lets say front month xyz futures are at 100 and the one year out contract is 80. Because of that, the 80 puts with one year of time on them are outrageously expensive (good for me, the potential seller) and in addition to that I can have a cost basis of 80-the premium and look forward to a long position at my cost basis if my risk materializes.
All this said, I do have some very strong warnings about selling options and I have rules that I follow. No one wants to end being the Victor Neiderhoffer poster child (a supposedly smart guy who bankrupt himself and almost bankrupt his broker by selling a lot of short options and then having it blow up in his face). How smart can you really be if you go bankrupt? Bad luck? I don't believe in luck that much. Anyway, when you are acting like an insurance company, it behooves you to analyze your risk properly or else sooner or later you are nearly guaranteed to reach financial ruin and unlike the real insurers...and as Neiderhoffer found out....the government isn't going to bail you out!
3.) I never sell more options than I am willing to take an assignment on. In other words, if I sold 5 wheat options above then I am going to be willing to be assigned 5 wheat at that price, even if the current market price is much lower. This is where some people get into big trouble.....by selling a lot of cheap out of the money options and then this being the one in 10 chance that you have to payout. This is a case that could lead to complete financial ruin. I never..ever sell more options than I am willing to take the long assignment on. NEVER. I just don't do that.
4.) Option premiums are volatile. If you remember the discussion from last night, one of the main determinants of an options premium is the volatility of the underlying security. When the security has been volatile, the implied volatility of the option is high and the price is high. Vice versa when the volatility has been low. So...you want to sell options after a good spate of volatility when the premiums are high. The options site I discussed last night has rankings of options based on the IV from cheap to expensive....it also has implied volatility charts that show how expensive an options is today relative to how expensive it was say 6 months ago, just based on the volatility. In general this translates to me seemingly paradoxically wanting to sell options into markets where the price is moving hard and fast against me. I did this not too long ago selling very expensive silver puts into a steep selloff and vice versa...selling covered calls into a sharp rise. And I'm very happy with the outcome so far.
5.) I don't just randomly sell options. I sell options that are expensive and in markets where I perceive that prices are not justified. By doing this I ensure that I'm getting good premiums, and hopefully stretching that 1 in 10 to be more like 1 in 100 by making informed choices. In other words, I'm trying to maximize the amount of premium I take in relative to the risk I'm taking on....just like any good insurer would do.
6.) I never sell naked (uncovered ) options into a market that I believe has a lot of room to move against me, because in that case even selling an amount I am willing to take an assignment on could be disastrous. I mean...there's no free lunch here....you have to be smart about what you are doing. In other words, I talked about recently selling COVERED calls against my long silver position. I'm bullish on silver and it has a lot of potential upside as far as I'm concerned. If I was selling naked calls, then according to my rules I'd have to be willing to take a short assignment at my cost basis which I am not willing to do...because there's no way I'd short silver in the low 500's...no way. On the other hand, I have been selling a lot of naked silver puts because I don't believe there is a lot of downside below 450 or so...and even if there was I could take the assignment and it wouldn't be a disaster.
7.) I'm reluctant to use the strategy in carry markets because the carry of a "normal" market works against the options seller. Let me give an example. Lets say you want to go long chick peas and the front month is 10 but the 1 year out contract is 20. Well, if I wanted to sell a 10 put, that's at the money in the front month but 10 cents out of the money on the deferred contract. So, I'm selling at the money, with a lot of time, and for a very small premium relative to the time since the deferred contract is 10 higher than the spot contract. Bad deal....I'll pass on that one.
8.) Transaction costs and bid offer spreads. Options can be illiquid. The manifestation of that can be in large bid offer spreads or the inability to find someone to take the other side of your trade at a reasonable price. Because of that, the odds are tilted further against someone who is actively trading options, because every time you go into the market you get hit on the bid offer spread and commissions to that broker of yours. So..an ideal strategy would minimze those costs relative to the premium you take in. The strategy I use minimizes those costs. I go into the market to sell expensive options on a limit price and then I'm done with those options brokers....I either wait for it to expire worthless, take the assignment or in some cases buy it back early (take profits) on a limit order. I want to minimize my dealings with the scalpers and the brokers. You won't find many brokers honest enough to tell it like it is just like Colonel Sanders rarely recommended the beef.
I've always felt that by giving my customers honest information and helping them to trade better that will offset the fact that I essentially discourage many types of trading. I'd rather have happy customers making money and referring new business to me than unhappy ones generating a lot of commissions....which is quite the opposite of the unleaded gasoline options salesmen you hear on the radio. It's a sore point for me because I feel that a few unscrupulous bad apples can taint the image of the whole industry. Thankfully we have the NFA to watch over telemarketing boiler rooms like that. Again...how dumb can people be? Why would someone out of the blue call you up on the phone to give you important investment advice? One last digression then I'll stop. I have heard about these boiler rooms doing the following...some broker calls say 1000 people with a single recommendation and another 1000 with the opposite recommendation. For the one that turned out to be right, he then calls them back with another iteration....after a single person has had say 3 calls with correct information (laws of probability...work the math) then that person is likely to think that the person on the other end is pretty smart and is now likely to invest although he is being scammed. This is the kid of thing you could be up against with the telemarketing securities salesmen. My recommendation is that as a matter of course when you get a telemarketing call you say "I'm not interested please put me on your don't call list" and hang up as quickly as possible. I get all that out of my mouth before they've finished their opening line. One time I even had a guy call back to tell me that his firm paid $20 for my lead and I'm just going to hang up??? I hung up again. I've never picked up the phone to do a cold call and I never will. I'm not going to convince anyone they should be trading futures...or buying El packa farms... because most people shouldn't. Most people don't have the money, the discipline, or the risk tolerance to do this. If you are successfully trading futures then the statistics say you are in an elite group.
So...I hope this sheds some light on the way I think about buying versus selling options. I believe there are probably people out there who have big computers and low transaction costs that do exactly what I'm talking about in the capacity of an insurer. In other words...what if...what if you had a computer program that picked option sales based on some mathematical criteria that basically turned it into an insurance salesman. So long as the computer is sure it's taking in more premium than it has to pay out over the long term, well you have created an insurance company in a box. I fully expect and believe that there are big fast computers sitting around in closets hooked to an options feed and a trading desk owned by smart people doing just that. Hey...maybe I'll come up with one of those...maybe I'll call it Long Term Capital Management!
