Options Selling: Trading Strategies and key analysis
Options Strategies? Sounds heavy? Already worrying you? Well, fret not! We shall help you crack this one quite easily.
Let’s start off by discussing the model of the game “lotto” where we bet on a lottery ticket and the odds of winning the lottery are very low. However, if we win we hit a jackpot. Similarly, when we trade-in options, we know it involves a certain level of risk but we still participate in them with the anticipation of a jackpot like the game above. But if you look at advanced options traders, they generally treat options as a hedging instrument or as a strategising instrument where the goal is to maximise profits while minimizing losses. That’s exactly where one wants to be!
In reality, there definitely exists some option trading strategies and these option trading strategies are designed in such a way that limits the risk quotient and opens a portal to unlimited profits.
Option strategies are the simultaneous, and often mixed, buying or selling of one or more options that differ in one or more of the characteristics. Here, characteristic means type of option (Call/Put), expiry date and the most common different characteristic of strike.
More often than not, mixing both Call and Put or having multiple expiries in a single strategy would allow us to take trades that aim to be a play on volatility in the underlying and not the direction. For now, let us start with restricting our focus on directional strategies.
Objective here is to get as little impact as possible from factors negatively affecting our option trade with the help of Options Strategy. Let us list some difficult situations and see which strategy can help us get rid of most negativity.
1. Long Holding Period or Time: As we all know passage of time hurts the option trades the most. In case the directional move does not come, and a day passes by, there is a visible impact on premiums of our options bought.
For any directional option trade that is expected to be held for more than 2 days (calendar not trading days), convert the Option Buy trade into Option Spread.
Strategy: Buy 1 Lot Call/ Put (Close to Current Market Price) + Sell 1 Lot higher Call/ higher Put (Close to Price Objective)
This will restrict your profits but it will definitely improve your profitability (premium earned vs premium paid) over a few days
2. Lower Sensitivity Options for longer duration: There are many trades where we buy a farther Call/Put since we have lower conviction. This is to make sure that if we are proven wrong, there is very less amount of money at stake. This is absolutely fine.
But, this trade will equally compromise our profit potential as well. A lot of traders here resort to a Ratio Strategy.
Strategy: Buy 1 Lot Call/ Put (Close to Current Market Price) + Sell 2 Lots higher Call/ higher Put (strike or two farther than Price Objective)
This will end up reducing our net premium outflow. With passage of time, it would create profits due to time value decay in 2 options in total being slightly more than the one bought.
This strategy over a period of time would pay off, with profits if proven right or with limited loss if proven wrong.
Since we have sold 2 options, here it is essential to define Absolute Stop Loss. Now, the maximum that we can make out of this ratio strategy is the difference between the bought strike and sold strikes minus the premium paid.
Absolute stop loss can be half of the maximum profit. Keep monitoring the trade and exit the trade with discipline if we end up seeing loss = Absolute Stop Loss.
PS: Ratios are generally preferred in rather quiet, consolidating markets where such violent moves are not expected
3. Options for Positional Trades: Finally, such option trades where we have a positional view of 7-10% higher/lower price objective. While, single option buy could give us decent reward compared to risk, the premium outflow could be too much. Spread and Ratios may not be most attractive considering the price objective because farther strike Options that we would want to Sell may not command so much premium.
Solution: Out of the money Butterfly Strategy. Out of the money means Higher Strike Call and Lower Strike Put options.
Strategy: Buy 1 Lot higher Call/ lower Put (couple of strikes farther than the current market price) + Sell 2 Lots higher Call/ lower Put (Close to Price objective) + Buy 1 Lot even higher Call/ lower Put (Keeping difference in all 3 strikes Bought/Sold and Bought same).
The cost of Butterfly is generally extremely low. Maximum Profit is the Difference between the bought and sold strikes minus the premium paid.
No stop loss, no time monitoring. Simply wait for the price objective to be attained. It will get sweeter as we move closer to expiry. Nonetheless, the worst is the price objective being attained in a few sessions. Even in that case, there would still be profit.
Remember to book profit when you achieve the price objective as the strategy starts losing money if the underlying expires beyond the farthest bought strike. The loss at any time will not be more than the premium paid though.
Once we understand this, it is always advisable to review these strategies on Option Pay-Off tool (with any option analytics software) before executing. This will help us know what our profit/loss could be across time and price.
These were some of the most popular directional strategies. They have helped me in optimising my option pay-off over the years.
How Option Sellers Benefit
As a result, time decay or the rate at which the option eventually becomes worthless works to the advantage of the option seller. Option sellers look to measure the rate of decline in the time value of an option due to the passage of time–or time decay. This measure is called theta, whereby it's typically expressed as a negative number and is essentially the amount by which an option's value decreases every day.
Selling options is a positive theta trade, meaning the position will earn more money as time decay accelerates.
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 (time value) and must make up the extrinsic value to profit from the trade. 4 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.3
However, time decay works well in favor of the option seller because not only will it decay a little each business day; it also works weekends and holidays. It's a slow-moving moneymaker for patient sellers.
Remember, the option seller has already been paid the premium on day one of initiating the trade. As a result, option sellers are the beneficiaries of a decline in an option contract's value. As the option's premium declines, the seller of the option can close out their position with an offsetting trade by buying back the option at a much cheaper premium.
Volatility Risks and Rewards
Option sellers want the stock price to remain in a fairly tight trading range, or they want it to move in their favor. As a result, understanding the expected volatility or the rate of price fluctuations in the stock is important to an option seller. The overall market's expectation of volatility is captured in a metric called implied volatility.
Monitoring changes in implied volatility is also vital to an option seller's success. Implied volatility is essentially a forecast of the potential movement in a stock's price. If a stock has a high implied volatility, the premium or cost of the option will be higher.
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. Delta measures the rate of price change in an option's value versus the rate of price changes in the underlying stock.
However, option sellers use delta to determine the probability of success. 8 A delta of 1.0 means 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 a delta of 1.0 means you have a 100% probability the option will be at least 1 cent in the money by expiration and a .50 delta has a 50% chance 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. the bid and ask prices for some option contracts. Notice the lower the delta accompanying the strike prices, the lower the premium payouts. This means an edge of some kind needs to be determined.
For instance, the example in Figure also includes a different probability of expiring calculator. 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