Before proceeding into trading any type of instruments and strategies you have to ask yourself:
- What is my goal?
- How much time can I dedicate to trading?
- What is my risk tolerance?
- What is my strategy?
Option selling (writing) offers reasonable profit potential and generally requires only a couple of hours a day of trading. Do not forget that just like with everything else, profit comes from taking risk. Option writing has been compared to picking pennies in front of an oncoming train. That comparison is very true since it can take just one badly handled trade and a good portion of earlier profits can be wiped out.
What is Options Writing/Shorting?
Let’s go over some fundamental concepts that every options trader should know: calls and puts.
Buying a call gives you the right, but not the obligation to take ownership of the underlying security or futures contract at the strike price. On the other hand, selling a call obligates you to sell the underlying security or futures contract at the strike price and for that obligation you receive a premium. For example, on August 25,2010 you sold US 30-year Treasury Bonds 137 calls for 40 and they expired two days later worthless. For the premium you received, you took the risk of that market moving above your strike price.
Buying a put gives you the right, but not the obligation to take a short position with the underlying contract at the strike price, if the underlying moves below your strike. Writing a put brings you premium, but you assume the risk of the market moving below your strike.
In a nutshell, when you buy options your risk is limited to the premium paid, and when you sell options the potential is limited to the premium received.
Think about selling options from this perspective: imagine that you own a home insurance business. You are collecting insurance premiums from your subscribers for an event probable, but unlikely to occur: cyclone, floods, or fire. You assess your risk and adjust the policy premium according to the area where the house is located and the value of the house. However, if the unlikely event occurs, for example a cyclone, you have to pay up your promise, which can take you out of business if you are not properly capitalised.
Things to consider
1. What markets are suitable for this type of trading?
It is important to look into liquidity for both options and the underlying contract. Liquidity can be determined by observing the availability of bid and ask and the difference between them (spread). You should start with strikes close to where the market is trading (near the money).
If bid and ask exist but spread is wide then it is likely that the market is not liquid and it might be advisable to stay away.
Assuming near the money strikes are liquid then next observe further away strikes. If those are liquid too, then you have one more step to go. Assess the liquidity of the underlying by observing the bid and ask sizes. You should see a minimum of 50 contracts on both sides at less active times. Any less and you know that this market can move fast on thin trading. In other words, just one big seller or buyer could move the market by a significant amount.
2. Another important aspect to consider is time.
As an options seller you do not want to expose yourself to too much time risk, since the magnitude of an adverse move could increase on a longer time frame. Bear in mind, option time value component decreases more rapidly during the last four weeks until expiration.
Options Writing Ideas:
- Look for overextended markets
- Sell an out-of-the money call if the market is overbought or
- Sell an out-of-the money put if the market is oversold.
When is a market overextended?
There are few indicators that could help you: moving averages, Bollinger bands, Relative Strength Index, etc. For example, if you have on your charts two different moving averages and determine that a cross gives you a buy or short signal, take this concept a little further. After you receive the signal, considering that the market moves favorably, you notice that the averages are far away from each other and also the market moved away from the fastest moving average. In this case, the likelihood of seeing a correction or consolidation is quite high.
Let’s say that you sold/wrote an option by following the above guidelines. Since writing options means taking on risk, it is not recommended to hold on the call or put till expiration. Try to liquidate the position (by buying it back) if conditions allow for a price that is about 20-30% of the premium received.
Your Options Trading Plan
Before you start shorting options please consider the following:
- Naked options shorting strategies can be very profitable but also very risky. At first you might want to consider signing up with an advisory service to help you out.
- Another aspect to consider is that recently, some futures trading brokerages have banned individual traders from writing naked options.
An alternative approach and a solution to the previous two concerns is trading credit options spreads - selling a closer strike and buying a further away strike of the same contract for a premium. The risk is limited to the difference between the short and long call, and the potential is limited to the premium difference between the two calls.