Selling Options, whether Calls or Puts, is a popular trading technique to enhance the returns on one’s portfolio. When performed on a selective basis, Selling Premium can prove successful, however, if you don’t follow some very specific guidelines, your long-term chance of profitability is unlikely. For those who Sell Options for Income, many are uncertain as to whether they are making money with their Options Trading because when included in their overall portfolio it can be difficult to measure each transaction’s success.
The first Options Selling Strategy to be cautious of is the Covered Call. When you Sell a Covered Call you are actually Selling a Synthetic Put. If you are not comfortable Selling Naked Puts, then you should not be comfortable Selling a Covered Call. A Covered Call enables you to own a Stock with unlimited downside risk and collect a Premium for the Call you Sold. Therefore, it is exactly the same as Selling a Put. If you are comfortable with the Covered Call, then, like all Options Transactions, there are numerous factors to analyze when entering any Options Position.
Now that the guidelines have been set and it is clear that Selling Options for Income can mean either the outright Sale of Calls and Puts or the Covered Call transaction, it is appropriate to look at what factors can make a trade more likely to be profitable than another. At the top of any list is 1) Liquidity or the percentage of the difference between the Bid and Ask of the Option Contract that you will trade. If you are giving away too great a percentage to the market-makers or algorithms, then the costs of entering the transaction are too high. One should look to trade an Options Contract that has a Bid/Ask Spread of less than 1.5%. While this may prove difficult at times, always consider that the more you give away to the Bid/Ask Spread, not only entering, but exiting the transaction, the more difficult it is to make money. In addition, all trade evaluations must consider the cost of commissions as well. While all of these costs make profitable trading that much more difficult, they must be included in your analysis. The Table below provides the liquidity of various SPY Options (SPDR S&P 500 ETF) for May expiration. The cheaper the outright Price of the Options the likelihood is that the Liquidity Percentage is higher.
In order to find a suitable strategy for trading, you must make a careful study of, at minimum, the following factors: 2) the Relative Strength Index of the underlying (extreme conditions tend to provide more interesting trading opportunities) the RSI is shown at the bottom right of the Table, 3) the Implied Volatility of the Options Chain (the IV is shown for each Options Quote), 4) Historical Volatility of the Underlying Contract (shown in the lower right hand corner of the Table and 5) a visual of the Implied Volatility Skew of the pricing of the Options (this analysis is shown by merely looking at the progression of the IV of the Options as they proceed farther out-of-the money). Like most Stock Options, SPY has a Skew which slopes towards the Put Side. By comparing the Implied Volatility to the Historical Volatility you can determine if the instrument you are evaluating provides the environment you are looking for to create the appropriate position with a reasonable risk/reward ratio.
Analyzing these factors can be difficult, but without the analysis you will not get good value. Whether you are getting Long Options going into earnings or Selling Options in anticipation of a lower Implied Volatility, you can be certain that without analyzing liquidity you will lose money in the long run. In addition, if you constantly Sell Calls with an Implied Volatility lower than the Historical Volatility of the Stock you own, you will be taking unnecessary risks. Sellers of Options should look to find Liquid Options with an Implied Volatility in excess of Historical Volatility which provides an opportunity to establish a position that will potentially provide good value. Additionally, establish a plan to exit the transaction if the market goes against you. Establishing a plan which evaluates the information provided in the table enhances your opportunity to make money dramatically. SPY may not currently provide an environment for executing a transaction that makes sense, but as a tool for analysis it is extremely helpful.
OPTIONS TRADING INVOLVES SIGNIFICANT RISK AND IS NOT SUITABLE FOR EVERY INVESTOR. THE INFORMATION IS OBTAINED FROM SOURCES BELIEVED TO BE RELIABLE, BUT IS IN NO WAY GUARANTEED. PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS.