Monday, February 18, 2013

Selling Option Premium

When it comes to trading options I have to admit that I have a pre-disposition to selling option premium vs buying it. My brain goes to great lengths to prevent me from buying option premium. Now this has not always been the case. When I first started trading options I was mostly a buyer, except for the old covered call strategy. Now theoretically you can find an option strategy that you pay for that has the same risk profile and probability for success. For example, you could buy a callspread vs selling a putspread.

So why do I prefer to sell options? The first reason I prefer to sell option premium is because of theta or time decay. Every option that trades is a decaying asset. By selling an option I get paid for everyday that goes by. Additionally I am selling an option that has no real or intrinsic value, based on the way I choose what to sell. What I mean by this is that lets say I sell a $25 put on MSFT for $1 when MSFT is trading for $27. The option has no intrinsic value because it is out of the money. MSFT would have to fall $2.01 to be in the money by a penny and would have to fall greater than $3.00 before I even begin to lose any money. I refer to this as my downside protection or cushion. You can think of it this way I am buying a stock with a fair market value of $27/share for $24, I know have an edge over every other market participant that went and paid $27 for the stock.

I especially like the fact that when I sell options I have more than one way to be right. Lets stick to the example of selling a $25 put on MSFT. I can make money the following ways:

1) MSFT continues to trade higher = Money in the bank
2) MSFT doesn't move and stays at $27/share at expiration = Money in the bank
3) MSFT trades lower but stays above my breakeven of $24.

So as you can see in this example I make money at any price greater than $24/share. Now lets compare that to buying options. When you are a buyer of options now you have time working against you. Now instead of making money for every passing day, you are now losing money through the theta or time decay of the option purchased. When you buy options you have to be right about the following: Direction, Timing, and Volatility. And as we know timing the market can be like catching a falling knife.

And then there is my least favorite way of trading...buying or shorting a stock outright with no options traded against the position. This is the way most retail investors trade. You know have a 50/50 shot at making money. And you only have one way to make it, if you buy the stock it has to go up in value to make you money (unless its paying a dividend of course), and if you short a stock it has to go down in value to make you money.

I don't know about you but selling options still sounds way more favorable to me. I will take multiple ways to making money on a trade vs a single way every day of the week.

Good Luck Trading!

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  1. Dominic, Do you use equity or index options? If index options, which ones do you use?

  2. I typically only use equity options. The markets are much tighter and liquid on equity options then they are on index options.

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