Last week I told you of some ways to take advantage of the great option leverage to gain an edge. The option trading focus we are discussing is on selling option premium. Don’t be afraid to use options as a tool in your investing/trading toolkit. They are powerful if used correctly. Time decay is the enemy of the option buyer but is the BEST FRIEND of the option seller. I’ll show you how that works below.
Sometimes we see a stock of interest and want to buy it, but would rather add it at a lower price. That is natural, we always want to get in lower and do not want to be stuck buying at top dollar. Selling put options are a great way to set you up with a multi-dimensional strategy but focused on potentially buying stock at far lower prices AND getting some income at the same time!
Let’s see how this works. You want to buy Boeing but as it has moved up to 100 you think it has move up too much and would like to buy it 5% lower or at 95. In fact, you have determined the market is overbought and could correct for a couple of months, which might help get the stock lower to your buy point, but you want to do something today. So, with the stock at 100 you could sell a 95 put (say it was currently 2 bucks) two months out and in the interim collect the option premium.
If you are correct and the stock comes down to say 94 by expiration of the put then you will take delivery of the stock at a price of 95, but since you collected $2 for selling the put your actual cost would be $93. Hence, you have been proactive. Now, what if the stock does not go down and hit your strike? Well, the put you sold would expire worthless and you would keep the $2 credit. Further, you could write the put one more time, collect whatever premium is there and wait to see what happens.
When we think about options it is often considered defensive, used as protection. Makes sense really, as options are a cheaper derivative of the stock, and if you have a long portfolio it’s always a good idea to hedge with some insurance (just in case). Trying to protect when it’s too late is akin to needing to buy fire insurance when your neighbor’s roof is flaming. A great way to protect a long portfolio is to sell calls or call spreads, collect the premium. It is often best to do this when the markets have had a good run or perhaps some news/event have may have changed the market character.
While some my want to buy volatility via the VIX or derivatives of it, I have found the best way to protect is using index option ETFs, selling calls/spreads on the SPY, IWM, DIA or even the QQQ. When volatility is low but rising (more on that below) the premiums captured are small and really provide only modest protection.
Finally, when are the best and worst times to be a seller of premium? Certainly during times of flat/low volatility we can capture option premium in a more stable environment. When the expectation is for little movement the odds are increased for a win (even though the gains from lower premiums is smaller). When volatility is trending higher you do not want to be selling premium, and that goes for call premium as well. The sharp snapbacks during a market downtrend make the odds for profiting a challenge. Remember, time is your friend as a seller – when volatility rises, time becomes your enemy, profits are made quickly on sharp moves. The longer you stay with a trade in a rising volatility environment the worse your odds of success.