Stock Options

1. Option selling: The holy grail of investments

"Selling options (stocks, commodities, futures, etc) has become for many the Holy Grail of Investments."

Consistent high returns. Option selling offers a unique opportunity for investors to generate steady, above-average returns with manageable risk. By capitalizing on the time decay of options, sellers can profit from the majority of options expiring worthless.

Statistical advantage. Approximately 80% of options expire worthless, giving sellers a significant edge. This statistical advantage, combined with proper risk management techniques, allows option sellers to potentially outperform traditional investment strategies.

Flexible strategies. Option selling provides numerous strategies to suit various investment goals and market conditions:

• Covered call writing for income generation
• Cash-secured put selling for potential stock acquisition
• Naked option selling for maximum premium collection
• Credit spreads for defined risk-reward profiles

2. Cash-secured put selling: A conservative strategy for income generation

"Cash secured put selling means you have cash or other securities to finance the purchase of the stock if your sold puts expire in-the-money and you are assigned the stock."

Low-risk income generation. Cash-secured put selling allows investors to generate income from idle cash while potentially acquiring stocks at a discount. This strategy is particularly appealing for conservative investors seeking to enhance returns on cash holdings.

Flexible outcomes. The strategy offers two favorable outcomes:

1. If the put expires worthless, the seller keeps the premium as profit
2. If assigned, the investor acquires the stock at a lower effective cost basis

Example application. An investor with $30,000 in a low-yield savings account could sell cash-secured puts on a desired stock. This approach can potentially yield returns of 10-15% annually, significantly outperforming traditional savings vehicles while maintaining a conservative risk profile.

3. The modified credit ratio spread: A powerful risk reduction technique

"The modified credit ratio spread as used in this book, instead of the simultaneous sell and buy of options we delay the buy side of the spread to a later date, if and when the market moves in the right direction, the direction favorable to us."

Enhanced flexibility. The modified credit ratio spread improves upon the traditional credit spread by delaying the purchase of long options. This approach allows investors to capitalize on favorable market movements and potentially increase overall profitability.

Risk reduction. By incorporating long options as partial protection against short positions, the strategy helps mitigate potential losses while still allowing for significant profit potential. The ratio between short and long options (e.g., 2:1 or 3:1) can be adjusted based on individual risk tolerance.

Strategic implementation:

1. Sell out-of-the-money options
2. Wait for favorable market movement
3. Purchase long options at reduced prices to create the spread
4. Continuously monitor and adjust positions as needed

4. Mastering the roll-out strategy to minimize losses

"I am surprised that in all the books I've read about option selling very few delve deeply in the loss protection benefits offered by the roll-out process."

Preserving capital. The roll-out strategy is a crucial technique for option sellers to manage risk and avoid significant losses. By closing threatened positions and opening new ones with later expiration dates, sellers can extend their time horizon and potentially recover from unfavorable market movements.

Key roll-out principles:

• Roll out when the underlying price approaches or reaches the short strike
• Reduce the number of contracts when rolling out to further decrease risk exposure
• Aim for a break-even or positive cash flow during the roll-out process
• Consider rolling to farther expiration dates for more time value and premium collection

Continuous adaptation. The roll-out strategy allows option sellers to adapt to changing market conditions and maintain their positions even in challenging environments. This flexibility is a key component of long-term success in option selling.

5. Choosing the right securities for option selling

"I would limit this trading strategy to selling strictly ETF stocks (Exchange Traded Funds) or index options."

Reduced volatility. ETFs and index options offer lower volatility compared to individual stocks, making them ideal candidates for option selling strategies. This reduced volatility helps minimize the risk of sudden price movements that could negatively impact option positions.

Diversification benefits. ETFs provide exposure to entire sectors or market segments, offering built-in diversification. This broader market representation helps mitigate company-specific risks associated with individual stocks.

Recommended securities:

• Popular ETFs: QQQQ, IWM, SPY, DIA
• Major indexes: SPX, RUT, NDX, DJX

Avoiding earnings surprises. Unlike individual stocks, ETFs and indexes are not subject to quarterly earnings reports, eliminating the risk of unexpected price movements due to company-specific news.

6. Balancing risk and reward in option premium selection

"For the more conservative options trader the March 54 or 55 calls together with the 37 or 36 puts would have still yielded decent returns at the same time providing greater protection against the volatility of the market."

Strike price selection. Choosing appropriate strike prices is crucial for balancing potential returns with risk exposure. Conservative traders may opt for strikes further out-of-the-money, sacrificing some premium for increased safety.

Expiration considerations. Selecting the right expiration date involves weighing time decay benefits against exposure duration. Shorter expirations offer faster time decay but may require more active management.

Premium evaluation factors:

• Current market volatility
• Distance from the underlying price
• Time until expiration
• Overall market trends and sentiment

Risk-reward tradeoff. Higher premiums often come with increased risk. Traders must carefully assess their risk tolerance and adjust strike prices and expiration dates accordingly to find the optimal balance.

7. Implementing a disciplined trading system for consistent returns

"By using a carefully planned, three-pronged system of trading, the risks associated with selling options can easily be conquered."

Systematic approach. A disciplined trading system is essential for long-term success in option selling. This approach helps remove emotional decision-making and ensures consistent application of proven strategies.

Three-pronged system components:

1. Selling naked options (puts and calls)
2. Implementing modified credit ratio spreads
3. Utilizing the roll-out strategy for risk management

Continuous monitoring. Regular position assessment and market analysis are crucial for timely adjustments and risk management. Establish clear guidelines for when to initiate trades, adjust positions, and exit markets.

Position sizing. Proper position sizing is critical for risk management. Start with at least six contracts per position to allow for potential roll-outs and contract reductions.

8. Navigating market volatility with strategic adjustments

"Refrain from trading when the market starts to move swiftly in one direction, either up or down."

Adapting to market conditions. Successful option selling requires the ability to adjust strategies based on current market volatility. During periods of high volatility, consider increasing the distance between strike prices and the underlying asset's price.

Volatility considerations:

• Low volatility: Sell options closer to the money for higher premiums
• High volatility: Increase out-of-the-money distance for greater safety
• Extreme volatility: Consider reducing or closing positions temporarily

Strategic pauses. During periods of extreme market movement, it may be prudent to pause trading activities and wait for more stable conditions. This approach helps preserve capital and avoid potentially significant losses.

Balancing act. While high volatility can offer attractive premiums, it also increases the risk of rapid price movements. Traders must carefully weigh the potential rewards against the increased risks in volatile markets.

9. Leveraging time decay for profit in option selling

"Option sellers make money when the options they sold are not exercised by the option holder on or before the options expire."

Time decay acceleration. As options approach expiration, the rate of time decay accelerates. This phenomenon, known as theta, is a key profit driver for option sellers.

Theta visualization:

Option Value
    |
    |      ____
    |    /
    |  /
    |/
    +----------------
              Time to Expiration

Strategic considerations:

• Sell options with 30-60 days until expiration to balance premium collection and time decay benefits
• Monitor positions closely as expiration approaches to manage potential assignment risk
• Consider closing or rolling positions when they reach 70-80% of maximum profit to free up capital for new trades

Compounding effect. By consistently capitalizing on time decay through multiple trades, option sellers can potentially achieve significant compounded returns over time.

10. Building a diversified option portfolio through layering

"What we are doing is diversifying into various positions at different strike prices and expirations."

Risk mitigation. Layering involves creating a diversified portfolio of option positions across different strike prices, expiration dates, and underlying securities. This approach helps spread risk and reduce the impact of adverse market movements on the overall portfolio.

Layering strategies:

• Sell options at different strike prices for the same underlying
• Stagger expiration dates to create a constant income stream
• Diversify across multiple ETFs or indexes to reduce sector-specific risk

Continuous management. Regularly evaluate and adjust the portfolio to maintain desired risk-reward characteristics. As positions expire or approach profitability targets, replace them with new trades to maintain consistent exposure and income potential.

Example layered portfolio:

• 5 contracts IWM June 180 puts
• 3 contracts SPY July 400 calls
• 4 contracts QQQ August 300 puts
• 6 contracts DIA September 340 calls

Last updated: July 29, 2024