This section and the associated pages are aimed as an introduction to a variety of trading strategies that follow a set of common characteristics. Selling options in spreads that have high probability of profit and make good use of capital are some of the key components. This page highlights these and other characteristics in more detail.
Selling options to collect premium
When trading options, a trader can either buy an option, or sell an option. Generally, buying most options is a low probability trade that has the possibility of a big return many times the initial price. In most cases, time eats away more premium than can be earned from guessing the correct direction and timing of a price move.
Selling options is a high probability trade that is likely to be profitable, but when it isn’t, it can lose a lot of money. Sellers count on time reducing premium, allowing the option to become worthless or cheap to buy back.
Buyers must be correct in picking a direction, and have the move happen before expiration, and enough to overcome the loss of premium from time decay. On the other hand, sellers must only pick a point where they believe the underlying security will not go by expiration.
Additionally, options are generally priced with more premium than the probability of price movement predicts. Stock index puts are especially overpriced most of the time, so selling is on average more likely to succeed than buying.
Hedging options to define risk
While selling an option has a high probability of success, there is significant risk of big losses in the times where underlying securities move more than expected. Selling an option by itself is called a naked option. Theoretically, there is unlimited risk in naked options, but in practice, even naked options have limits to losses. Regardless, brokers don’t allow inexperienced traders to have naked option positions, and IRA accounts are not allowed to have naked options in any situation.
Because of these restrictions, my risk tolerance, and the fact I trade mostly in IRA accounts, I avoid naked options. I do this by hedging every option I sell with at least one option I buy further out of the money. This is called a spread. By doing this, I put a cap on how much can be lost on a trade. For example, if I sell a put with a $100 strike price, I might buy a put with a $95 strike price. If the underlying security drops below $95, my loss on the spread is limited to $5 per share, or $500 for the contract ($5 x 100 shares). Often this type of arrangement is called a defined risk trade, because the risk is fully defined, while a naked option has undefined risk.
The trade-off of limiting risk is that the reward is reduced by premium paid for the option that was purchased. The absolute amount of premium collected from the spread is less than the premium from just selling an option, but in most cases the amount collected as a percentage of capital at risk is higher. The other trade-off is that a hedged sell/buy spread often has a lower probability of profit than a naked option. This trade-off has to be managed by choosing strike prices where the probability of profit is not changed significantly.
Focus on high probability
Choosing the best strike prices for high probability of success is one place where data analysis can be a big help. The Greeks can give traders insights into probability and potential for profit. For most strategies I use, I focus on selling spreads far away from the current underlying price. These options have a high likelihood of quickly decaying in value. The exact distance from the current price varies based on the strategy elements.
In most cases, I use Delta as the key parameter to pick the distance from the current underlying price. Delta is the measure of movement in premium for a dollar change in the underlying security price, but it also is a measure of probability of the option expiring in the money. This concept is covered in more detail on the Greek webpage on Delta.
The bottom line is that I use the Greeks, especially Delta to choose options with strike prices likely to be profitable.
Taking both sides maximizes capital
Whenever we sell an option or an option spread, we tie up capital. For example, if we sell a put with a $100 strike price and buy a put with a $95 strike price, the broker will set aside $5 per share or $500 per contract ($5/share x 100 shares). Actually, we tie up a little less because we collect premium from this transaction. So, if we collected $100, we would have $400 at risk.
Often, when I open a credit spread (I collect a credit when the option I sell is more expensive than the one I buy), I’ll open another credit spread with the other kind of option. If I opened a put spread, I’ll also open a call spread. If I open the second spread with the same width, I don’t risk any additional capital from my broker. Let’s build on our previous example- In addition to the put spread, we could sell a call with a $120 strike price, and buy a call with a $125 strike price. The risk is also $500, but we are risking the same $500.
How is it the same $500 risk? Well, as long as both spreads are on the same underlying and expire at the same time, and the spreads don’t overlap, there is no way that both spreads can be in the money at the same time. If the short put is in the money, the short call isn’t. So, from the standpoint of the broker, only $500 can be lost.
This isn’t to say that adding a second spread doesn’t take on more risk to the trader that sells this second spread. The maximum loss doesn’t increase, and will actually decrease because additional premium will be collected from the second sale. However, the second sale provides a second way to lose money, so the probability of profit decreases.
Taking both sides of a trade with both a put spread and a call spread allows a trader to put on two high probability trades on with the same capital. I don’t always do this, but it is a key consideration in how I think about making the best use of capital in constructing trade strategies.
Avoid betting on price movement
What is the stock market going to do tomorrow? Or next week? Will there be good news or bad? How will the market react? I don’t know. I may have an opinion, but so does everyone else. What makes my opinion better than the market? The market efficiently takes into account all the data available and finds a balance for supply and demand. Sometimes the market goes up when I think it should go down, and sometimes it does the opposite.
Of all things that impact the value of option premium, the least predictable is the direction of changes in price. Because of that, I try to stick to strategies that don’t depend on underlying prices to move in one direction or the other. Occasionally, I’ll structure a trade to either ride the current momentum of price changes, or be contrarian, and I find I’m almost always wrong, at least in timing. I may think that a trend is about to change, but the trend waits three weeks too long, which in my world of options means forever. So, I’ve learned to be neutral in my price outlook for my option trades.
From a Greek standpoint, this means that I like positions that are Delta neutral. The total of. the Delta values should be close to zero. Playing both sides with both puts and calls helps with this, along with other strategies that provide a neutral bias.
Avoid drama- get in early, get out early
I’ve tried a lot of different timeframes for selling options. Most people are aware that the closer an option gets to expiration, the faster it decays. The logical conclusion is to sell options close to expiration to gain the most. However, it doesn’t really work that way.
As options approach expiration, the only options that still have premium are those with strike prices very close to the current underlying price. When someone sells options very close to being in the money, it doesn’t take a very big move of the underlying to put the option into the money.
From a Greek standpoint, Delta can change very quickly as underlying prices change. This change is measured by the Gamma of the option, which increases significantly as expiration approaches. Positions can quickly switch from profit to loss. Managing positions near expiration requires a lot of attention and can get very stressful.
To avoid this stress, I open options positions weeks or months out from expiration. The timeframe I pick depends on the strategy I use for the current market environment. Typically, I try to close trades about half way between when the trade was opened and expiration. Again, timing depends on the type of trade and the market condition.
The common aspect of this approach is that I have plenty of time to make decisions on when to open a trade and when to close it out. Often, I have no open trades that are expiring during the current week, and many times none that are expiring in the next week. I like having nothing urgent.
How can I make money if decay is slower weeks before expiration? Remember that as expiration approaches only the strike prices near the current underlying price have value? My goal is sell options that are far away from current prices and lose all their value way before expiration. Once the premium is mostly gone, I close them out and put the capital to use on another trade. If the trade goes bad, I close it before the losses get too high and start another trade with better potential.
Make sure time is your friend
The only thing that is for sure in options is that as time passes, options reduce in value. At expiration, the option will either be worthless, or will be worth the difference of the strike price from the price of the underlying security. Before expiration the option will have additional value based in large part on how much time is left to expiration.
Traders that own options have time working against them, eating away at the time value of the option, while sellers have time working for them. So, a conclusion that might be drawn is that a trader should only sell options- but it isn’t that simple. There are lots of reasons to buy options, so the better take-away is to choose strategies that minimize the impact of time when buying options, and maximize the impact of time when selling options.
The key is that time doesn’t treat all options the same- on an absolute basis, or on a percentage basis. And when a strategy involves buying one option and selling another, the impact of time can be very different depending on which strike prices are chosen.
The impact of time is measured through the Greek parameter, Theta, that quantifies how much an option premium is expected to change in a day, based just on time passing.
Learn to speak Greek
The Greek parameters are invaluable in analyzing option positions, both before opening a trade, and in managing a position in the portfolio. There’s no excuse not to be familiar with the Greeks- this site has a whole section dedicated to them. In particular, know the big three: Delta, Theta, and Vega. Learn them and use them.
Similarly, learn how other pricing relationships factor into option premium pricing. Learn about Implied Volatility and IV skew.
Take advantage of volatility changes
The more I trade options, the more I believe that volatility changes are the key to success. When I think of volatility, I’m thinking of the Implied Volatility of options, and particularly, VIX. When VIX is high, say over 20, it is a just a matter of time before it gets lower. When VIX is low, say under 15, it may stay low for some time, but eventually will spike up.
There are strategies that work well for high volatility that anticipate the impact of volatility reduction. There are other strategies that do well in low volatility to take advantage of either extended up trends, or a sudden spike up in volatility. It is best to pick a strategy that matches the current volatility environment.
Option premiums and returns are skewed
When looking at an option table that contains Implied Volatility, there is almost always a lot of variation in values. For most stock indexes, options with lower strike prices have higher implied volatility than option at higher strike prices. Options with higher Implied Volatility have more premium relative to options with lower Implied Volatility. For individual stocks that are rapidly increasing in value or for many commodities, the opposite is true- higher strike prices have higher implied volatility.
Why does this matter? Because wherever possible, the odds favor selling options with higher Implied Volatility and buying those with lower Implied Volatility. A strategy that is built on taking advantage of this is the back spread. I often sell an option and buy two options with half the Delta, while collecting a premium of 10% or more of the width of the spread. This only works when Implied Volatility is skewed toward lower Deltas having lower Implied Volatility. When Implied Volatility is skewed the other way, I normally only sell credit spreads, or perhaps avoid taking a position on that side of the trade.
Skew of Implied Volatility, along with level of Implied Volatility are key drivers in determining the strategy to take at any given time.
Major indexes are more predictable than individual stocks
I generally sell option spreads that are based on underlying securities that are major indexes like the S&P 500 (SPY or SPX), the Nasdaq 100 (QQQ or NDX), the Dow Jones Industrial Average (DIA), or Russell 2000 (IWM or RUT). For most of these indexes, there is an ETF that tracks the index with options on the ETF, or options on the index itself.
Many people tend to trade options on individual stocks. Individual stocks generally have higher Implied Volatility than indexes, but that volatility is tied to unpredictable movement. Individual stocks can move huge amounts based on company news or earnings announcements. These price changes can be much bigger than expected moves based on option prices. It is very easy to lose big.
On the other hand, indexes are an averages of dozens, hundreds, or even thousands of stocks. Big individual moves are balanced out by the other stocks in the index, so moves are much less likely to be outside of those that are statistically expected. Because of this, I have most of my option positions in indexes, not individual stocks.
Picking the right strategy to enter is only half the trade
Once I enter a position selling options, the next phase of work begins- managing the trade. When selling options, most ways of managing a position are backward from trading regular equities. With most equities, the plan is to quickly cut losses and let winners ride. When selling options, it is likely that positions will often show losses at times, and the amount that can be gained is limited. The time factor of expiration also factors into the decision making of how to manage a trade- when to close, roll, or let ride. And different strategies have different goals, some even depending on which way the market moves.
For each position that is open, I have to determine my plan for management- what will cause me to close the trade, or roll the trade to different strikes or expirations, or when to let it ride.
For winning trades, my plan is usually to close out when the premium has decayed to a point that there is so little premium left that it is more beneficial to put the capital at risk to use somewhere else rather than wait for the last bit of premium to decay. In the few situations when I have long option positions, the challenge is to capture gains before reversals in pricing can take the gains away, while leaving room for additional profit.
For losing trades, the time to exit or roll is when the probability of greater losses outweighs the potential gain. If the short term odds are 50% that the underlying will go up, and 50% that it will go down, I try to avoid positions where one direction is a huge loss and the other is a small gain. When selling options, this is always the situation for really big moves, but when small moves are either big losses or small gains, it is time to get out. This is when options are sold well out of the money and then price moves beyond the short strike price. Exactly where to act is a decision to be made based on time left, and often the direction of the move. But as the odds move against the position, capital preservation outweighs profit.
I’ve found that the most difficult part of trading is accepting losses. I always think of reasons why I think things will turn around and go in the direction of my position. With rules and guidelines to trigger me to act, I can keep my losses relatively small, and save my capital for new positions more likely to be profitable.
Specific strategies
In this section of the website, I have additional pages of specific strategies I’ve found helpful, and are the basis of most of my trades. My most used trades are a combination of credit put spreads and credit call back spreads. But all the above factors are considerations as to how these or other strategies are implemented and managed. I have written a brief summary of my favorite strategies, and have numerous posts describing most of them in detail.
