The Ins And Outs Of Selling Options

I wanted to learn more about options and I figure you might too, so I did a search and came up with this really good article from Investopedia.

In the world of buying and selling stock options, choices are made in regards to which strategy is best when considering a trade. If an investor is bullish, she can buy a call or sell a put, whereas if she is bearish, she can buy a put or sell a call. There are many reasons to choose each of the various strategies, but it is often said that "options are made to be sold." This article will explain why options tend to favor the options seller, how to get a sense of the probability of success in selling an option and what risks accompany selling options.

Time Is on My Side

The phrase "time is on my side" is not just popular because of The Rolling Stones, but also because selling options is a positive theta trade. Positive theta means that the time value in stocks will actually melt in your favor. You may know that an option is made up of intrinsic and extrinsic value. The intrinsic value relies on the stock's movement and acts almost like home equity. If the option is deeper in the money (ITM), then it has more intrinsic value. If the stock moves out of the money (OTM), then the extrinsic value will grow. Extrinsic value is also commonly known as time value.

During an option transaction, the buyer expects the stock to move in one direction and hopes to profit from it. However, this person pays both intrinsic and extrinsic value and must make up the extrinsic value to profit. Because theta is negative, the option buyer can lose money if the stock stays still or, perhaps even more frustratingly, if the stock moves slowly in the correct direction but the move is offset by time decay. Time decay works so well in the favor of the option seller because not only will it decay a little each day but it also works weekends and holidays. It's a slow-moving money maker for patient investors.

Volatility Risks and Rewards

Obviously having the stock price stay in the same area or having it move in your favor will be an important part of your success as an option seller, but paying attention to implied volatility changes is also vital to your success. Implied volatility, also known as vega, moves up and down depending on the supply and demand for option contracts. An influx of option buying will inflate the contract premium to entice option sellers to take the opposite side of each trade. Vega is part of the extrinsic value and can inflate or deflate the premium quickly.

An option seller may be short on a contract and then experience a rise in demand for contracts, which, in turn, inflates the price of the premium and may cause a loss, even if the stock hasn't moved. In most cases, on a single stock, the inflation will occur in anticipation of an earnings announcement. Monitoring implied volatility provides an option seller with an edge by selling when it's high because it will likely revert to the mean.

At the same time, time decay will work in favor of the seller too. It's important to remember that the closer the strike price is to the stock price, the more sensitive the option will be to changes in implied volatility. Therefore, the further out of the money a contract is or the deeper in the money, the less sensitive it will be to implied volatility changes.

Probability of Success

Option buyers use a contract's delta to determine how much the option contract will increase in value if the underlying stock moves in favor of the contract. However, option sellers use delta to determine the probability of success. You may remember that a delta of 1.0 means that an option will likely move dollar-per-dollar with the underlying stock, whereas a delta of .50 means the option will move 50 cents on the dollar with the underlying stock. An option seller would say that a delta of 1.0 means you have a 100% probability of success that the option will be at least 1 cent in the money by expiration and a .50 delta has a 50% chance that the option will be 1 cent in the money by expiration. The further out of the money an option is, the higher the probability of success is when selling the option without the threat of being assigned if the contract is exercised.

At some point, option sellers have to determine how important a probability of success is compared to how much premium they are going to get from selling the option. Figure 2 shows the bid and ask prices for some option contracts. Notice the lower the delta that accompanies the strike prices, the lower the premium payouts. This means that an edge of some kind needs to be determined. Various calculators are used other than delta, but this particular calculator is based on implied volatility and may give investors a much-needed edge. However, using fundamental evaluation or technical analysis can also help option sellers.

Worst-Case Scenarios

Many investors refuse to sell options because they fear worst-case scenarios. The likelihood of these types of events taking place may be very small, but it is still important to know they exist. First off, selling a call option has the theoretical risk of the stock climbing to the moon. While this may be unlikely, there isn't an upside protection to stop the loss if the stock rallies higher. Therefore, call sellers need to determine a point at which they will choose to buy back an option contract if the stock rallies, or they may implement any number of multi-leg option spread strategies designed to hedge against loss.

Selling puts, however, is basically the equivalent of a covered call. When selling a put, remember the risk comes with the stock falling, but a stock can only hit zero and you get to keep the premium as a consolation prize. It is the same in owning a covered call - the stock could drop to zero and you lose all the money in the stock with only the call premium remaining. Similar to the selling of calls, selling puts can be protected by determining a price in which you may choose to buy back the put if the stock falls or hedge the position with a multi-leg option spread.

Selling options may not have the kind of excitement as buying options, nor will it likely be a "home run" strategy. In fact, it's more akin to hitting single after single. Just remember that enough singles will still get you around the bases and the score counts the same.

by Ryan Campbell,

Ryan Campbell, CMT has worked in the financial industry for approximately a decade. He has worked as a full-service broker, a banker and is currently a content producer for Investools.com. He writes a daily market commentary and develops courses on trading equities, options, futures and currencies. He has contributed as a columnist to other financial publications. Ryan is also an active member of the Market Technicians Association and was the recipient of its prestigious Chartered Market Technician designation.