Selling options is one of the most successful options strategies but hardly anyone ever talks about it. The reason is option selling is deemed “not sexy” and will not provide a high return. These days, the word 2x or 3x gains from options trading is so common that many beginner investors only listen to those sales speeches. However, chances are this investor will realize so enough that they are losing money and will quit in the near term.
80% of all options held through expiration will indeed expire worthless. Furthermore, experts estimate that only 10% or less of all options will ever be exercised. Most traders and investors, especially in the commodities arena, have been taught from their trading lesson that to turn a profit, a series of small losses must be accepted to make that one big gain. From my experience, most beginner investors start trading options through buying. Buying options are relatively a lot cheaper than selling because selling options require collateral. It is the potential for this one big gain that keeps traders and gamblers alike coming back time after time and losing money time after time.
That is why is it so sad to see many beginner investors jumping the gun, losing their hard-earned money, and badmouthing options trading as one of the worst and most dangerous ways of making an income. In this blog, I hope to clarify any doubt on why options trading is a good way of trading options and why selling options is a more risk-adjusted way of making money. But if you would like to know more about options trading, we have an in-depth how-to blog on trading options.
The Pros of selling an Option
First and foremost, this blog is about why selling options is the best strategy. Therefore, there will be slight biases in the argument. However, we do add the cons of the selling option down below for fair comparison.
Most Expire Worthless
Futures magazine published a study in 2003 (Summa, 2003) regarding percentages of options expiring worthless. The study tracked options in five major futures contracts: the S&P500, the Nasdaq 100, Eurodollars, Japanese yen, and live cattle. It was conducted over three years from 1997 to 1999. The research came to major conclusions:
- On average, three of every four options held to expiration expire worthlessly (the exact percentage was 76.5%).
- The shares of puts and calls that expired worthless are influenced by the primary trend of the underlying market.
- Option sellers still come out ahead even when they go against the trend.
So think about it this way. If you have ever lost money buying options, imagine that you had made a premium for every option you held that expired worthless. Would you be ahead right now? Of course, you can also lose money selling options. There is no free lunch. But in option selling, there are multiple ways you can make money but only one way you can lose it.
Taking Profits Becomes Simple
“cut your losses short, and let your profits run”. Every trader is drilled to memorize this quote. True to a certain degree, however, applying it in real-life trading accounts is extremely difficult, if not impossible. Cutting losses and letting profits runs sounds good on paper, but the psychology of it goes against human nature. Emotions are a critical enemy of traders, and of all emotions, there is no damage to a portfolio as the feeling of hope.
When one sells an option, as opposed to trading the outright futures contract, the decision of when to take profits generally becomes one that you no longer have to make. The market makes it for you. As long as your option is not in the money, the value of your option will eventually deteriorate to zero at expiration.
Unlike a buyer of an option, the risk of option selling is the amount of collateral owned. Regardless of the label of unlimited risk in selling short options, option selling risk can be just as definable and controlled as any other type of futures or stock trading risk. And there are multiple ways to manage risk, depending on the investor’s risk tolerance. This is mentioned here as an advantage only so you will know that you can control option selling risks and have several methods available to you.
Time is on your side
Unlike buyers of an option. An option seller has time on their side. In simple terms, as long as the stock remains above (puts) or below (calls) the strike price, the option seller is rewarded with the premium. So most option sellers put a strike price far out of the money of the stock.
I love the analogy put up by James Cordier & Micheal Gross in the book ‘The complete guide to option selling’ where he compares selling options to being a football team that plays on defense for an entire game. The scenario is your team have scored a few goals and the best strategy right now is to defend the goal post at all time. As every minute passes by, the opposing team has lesser time to score a goal to beat you. The opponent can’t step out of bound or call time out to stop the clock. The best part is, that if you begin to feel uncomfortable at any point in the game, you can simply quit.
As an option seller, the passage of time is your greatest ally.
The Cons of selling an Option
Well of course there are some bad points on option selling. I believe that by sharing two sides of the coin on selling options. You as an investor will be more mentally prepared and would have a higher chance to try option selling.
Let’s get the elephant out of the room. Options selling has its risk, a lot of risks. If you purchased Apple stock sell options at a strike price of 180 and Apple falls to over 150, you are still obliged to buy the stock once the option expires. However, this risk compared to buying options can be calculated and measured.
Selling options is like watching a boxing match between a bull and a bear. As they fight, money will flow everywhere out of the ring. An option seller’s job is to not be involved in the fight and view it as a spectator. As long as you are not directly involved in the fight and the match ends, you get money from the fight.
The idea of how option seller makes money using that analogy is whatever happens in the stock market. As long as the options seller is not in the money, they will be able to make a premium.
Sad to say, no matter how much the stock goes up or down. An options seller can only make a profit based on the amount of premium it provides. It is for this reason that traders chasing the “big score” and trading the market for the adrenaline rush generally are not attracted to the concept of option writing. To use a baseball analogy, an option writer is an investor who is willing to give up his chance of hitting a home run in favor of consistently hitting singles over and over again.
Seller of options requires collateral enough to be able to purchase 100 shares of XYZ company. That means if you would like to sell an option put the position of Apple with a strike price of $180. You would be required to have $18,000 minus the premium of collateral to purchase the option.
When trading option selling correctly, the investor can only make upwards of 2 to 4% of the collateral amount monthly. That is why for many beginner investors, selling options may not want they can afford to do so. Not only that, to their small portfolio, earning 2 to 4% per month is not enough gains to them.
Why should I sell Options?
Now that you know why options selling has its pros and con. You as an investor can then be ahead with making rational decisions.
Unlimited risk for option selling is the constant danger for option sellers. These are option sellers who will always remain calm and not take unnecessary risks selling options that are near the strike price.
Warren buffet’s main option strategy is selling put. It is not widely known to most investors. Option selling is not sexy and warren buffet is a value investor. His investment strategy is to put an option strike price that he feels is the right strike price to purchase or sell the stock. In May 2022 the S&P500 crashed by over 20%, and Warren Buffet was able to seize the opportunity to purchase some of his high conviction stocks like Apple. In total, he bought
How to get started
Apart from getting to know about selling options from books. Investors need to know how to do the proper trades through their software broker. Every software broker has its own smart or unique functions. As an investor, you will need to know how all the function works. Most importantly, know how to close the position correctly.
Secondly, it is always safer to have a buddy or mentor to guide your every step of the way. By learning through real-life experience from others first hand. Investors can learn and better themselves faster.
Lastly, remember to always set stop losses and set realistic expectations when closing a position. Write down all the gains and losses on each trade. Have a remark section to remind yourself and learn from those mistakes.
Think like an Option Seller
Unlike many analysts and traders, we do not attempt to guess what market prices will do today, tomorrow, or next week. Here is why
- Short-term trading is too difficult. 99% of traders lose money.
- The market can move very sporadically over short-term periods but over the long term will always have to adjust to reflect fundamentals.
- As an intermediate-term option writer, short-term market gyration does not call for concern. You are concerned about long-term market direction and, most importantly, where prices won’t go.
This is the approach to follow because we never know how the market will react on a daily basis. Whether the stock moves lower, stays the same, or even moves somewhere higher. As long as the futures price is not in the money into expiration, it expires worthlessly. Although this type of thinking can be difficult at first for the futures trader used in daily activities, selling options will be able to generate consistent returns.