Let’s delve a bit into one of the more advanced options concepts — selling time premium. Traders that are new to options often begin with just Call/Put purchasing and perhaps Covered Calls. Then they begin to wonder what the other side of the options transaction is like. Remember that for every single listed option trade, there is a buyer and a seller — usually it’s the public buying options and the Market Makers handling the order flow and maintaining an orderly 2-sided market.
When 1 to 2 weeks remain before Monthly options expiration (the new Weekly options are a whole ‘nother story), that’s often a very attractive time to sell option premium due to the rapid decay that will occur by the Friday when Monthly options cease trading. First, let me mention that we’re generally not a fan of ever selling “naked” options (not covered by another option or underlying) … unless perhaps you run a giant hedge fund. Your risk can be unlimited, the margins are very high and you can have 10 winners in a row and 1 big loser can wipe out all your profits and more. So one of my preferred ways to garner that rapid decay in time premium and Theta is to sell front month out-of-the-money Call or Put spreads ahead of Expiration. This is known as a Credit Spread, also a Vertical Call or Put Spread and it’s a great way to collect cash using options.
The “spread” part means that we are selling one option and buying another in the same amount, in 1 simultaneous transaction and receive a net “credit” (cash) for the trade. So if you are looking at doing this, you need to find a stock/index/ETF that will either go your direction OR be flat heading into Expiration. That’s the nice thing about these Credit Spreads is that you get a “cushion” within which the security can move against you and you can still make the maximum profit on it.
Ok, let’s examine (for educational purposes) a real-life example with real-time prices — on the S&P 500 Index ETF (SPY), which basically mimics 1/10 the performance of the SPX index. Let’s assume you are Bullish/Neutral on the SPYders heading into next month’s Friday’s final trading day for March options, the 19th. Remember that we prefer to wait until about ½ weeks before the monthly expiration due to the rapid time decay that occurs then, but for let’s just use this for an example based on today’s prices.
SPY is currently at 134.35. The SPY has 1 point increment on its strike prices and is very liquid with small bid/ask spreads, so securities like this are particularly attractive to sell premium on — you don’t give up as much “edge” to the market makers with wide big/ask spreads and execution problems. And while the SPY itself is fairly high-priced for a stock, being above 100, the implied volatilities on its March options really aren’t that high. The At-The-Money (ATM) Straddle is only trading around a 14% implied volatility currently. So with our Bullish/Neutral theoretical stance (not a trade recommendation, just for educational purposes only), we would be looking at March Out-of-The-Money (OTM) Put spreads to sell.
If one is banking that the SPX itself will go out above the key 1,300 level on March expiration, we could look at selling the SPY March 130/128 Put spread as an example. Currently, this spread is 0.26 by 0.28 — the max risk is the premium received minus the difference between the strikes — so in this case if we sold it at 26 cents, the max risk is 1.74 per spread traded. That’s a 14.9% return on risk in 4 weeks (not including commissions), also with a price cushion of approx 4.1 points on the SPY to breakeven level of 129.74 (around 3.2% downside protection). Again, we would prefer to put on this trade with a 1 point strike differential (rather than 2 in this case) and closer to expiration – and we generally would look to garner 15% to 60% max potential gains on our front-month credit spreads.
Basically in this case, if we sold this 2 point spread for 0.26 ($26), then $174 is required for each spread by most brokers as the margin required (maximum risk). If the stock goes out above 130 on March 19th, the 2 options expire worthless and you keep the $26 credit received for a nice gain. You also have that cushion whereby the SPY can go over 3% against you and you’ll still profit. That’s why credit spreads in this manner have a high probability of success – so you don’t have to be correct in your directional pick, you just can’t be dead wrong. Your own personal risk/reward comfort level should help determine what spreads you feel most comfortable selling.
What are your comments/questions/thoughts about this subject?