Sunday, September 29, 2013

Selling Options

In the last two posts, I have discussed about buying options, both call options and put options.  Today, I want to discuss the opposite : Selling Options.

For the Options (Put or Call) buyer, we have limited risk (the premium we paid) with unlimited potential rewards.  For the Options (Put or Call) seller, we have limited reward (the premium we received) with unlimited risk.

It is for this unlimited risk that most traders avoid options selling.

If you avoid options selling, you will miss out the unique features of Options trading.  And, thus, the advantages of using Options in trading.

Unlike other products (Stock, Futures, Forex, etc)  for trading, Options has an unique feature called Time Decay.  All Options lose time value every day.  It loses time value at a faster rate as you get closer to the expiry date.

The other unique feature is Expiration.  Option becomes worthless when it expired, regardless whether it still has any intrinsic value or not.  Say, you bought a Call Options, it has an intrinsic value of $5.00 on the last day of trading.  You forgot to close your position, by selling your Call Options.  The next day, it becomes worthless, even it has an intrinsic value of $5.00.

When we buy Options, time is working against us.  When we sell Options, time is working for us.  It is this unique feature that give seller the advantage and edge in trading options.

When we buy Options, say Call Options, we need not only be right in our direction (price rise in future), we need to be right before expiration.  Not only price need to rise, it need to rise by a sufficient amount to offset the time decay for us to make a profit, before expiration.

For Options seller, say Put Options, we just need to be right that price didn't drop a lot.  We will make a profit 4 out of 5 scenario below:

1. Stay flat (win)
2. Rise a little (win)
3. Rise a lot (win)
4. Drop a little (win)
5. Drop a lot (loss)

Say, we have established a bullish view on Ford Motor (F) stock.  On 20 August, price closed at 16.31 above the support at 16.00.  We believe that the retracement has stopped.  Price should went back up to test the last swing high at 17.67.  However, if our bullish view is wrong, we are prepared to stop loss at the next support at 15.18.

Thus, we sold 10 contracts of F Oct19'13 15 Put @0.30.  We received $300 (excluding commission) for the premium.

From 20 August to 19 October, F stock price can stay flat, rise a little, rise a lot or drop a little (above the Strike Price of 15.00), we will get to keep the full $300 (excluding commission).

Price close at 17.05 on 27 September.  Let's review it again in mid October or when it expired.

Similarly, for selling Call Options, we will make profit 4 out of the 5 scenario below:
1. Stay flat (win)
2. Rise a little (win)
3. Rise a lot (loss)
4. Drop a little (win)
5. Drop a lot (win)

It is this unique advantage and edge as a seller that got me interested in Options Trading, on top of my Futures and Forex trading.  Options selling is effectively an 80% (4 out of 5) winning system.

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