Despite the higher opportunities to make money, selling options can also be very risky, especially when the market moves against you and you don’t have an exit strategy in place.
This article discusses the various advantages and disadvantages of selling options, why it may be advisable, how to sell options with differing strategies, how they can lead to losses, etc.
Keep note that, I am firmly against options, but understand people want to take higher risks to get the capital needed for them to achieve their goals. With that in mind, I am here to fully educate my audience to give them as much knowledge as needed to help them with their trading goals.
Advantages And Disadvantages of Selling Options
Selling options give the potential to stack large amounts of money. Apart from this, below are the major advantages of selling options instead of buying:- It helps you create a consistent income stream.
- It allows you to use the idea that complexity and volatility are overstated to your advantage.
- Selling options allow you to cover trades, using options to always stay ahead.
- When you sell options, you will collect a premium when the position is open until it expires.
Below are the disadvantages of selling options.
Disadvantages Of Selling Options.
Most importantly, to sell options profitably, you need a considerably large amount of money and time. This is usually challenging, especially for newbie traders. Other cons of selling option include:- It is time-consuming.
- It is hard to predict the stock market’s future.
- You can’t get “to the moon” by simply selling options.
Types Of Trading Strategies
Naked Calls
Naked calls are an options strategy that allows you to sell options without having a short position in the underlying security. This is often used when you expect the stock price to trade below its strike price at expiration.
However, note that the profit is limited. The highest gain possible with this strategy is the amount of premium collected after selling the option. It is achieved when you hold the option through expiration until it expires worthless
However, note that the profit is limited. The highest gain possible with this strategy is the amount of premium collected after selling the option. It is achieved when you hold the option through expiration until it expires worthless
Unlike its gain, the involved risk is unlimited. Although most options expire worthlessly, making you have more winning trades than losses, you can lose your entire gain with just one single bad trade. This is because of the unbalanced risk versus rewards ratio characterized by the strategy. So for example, if you sell a stock for a $1 premium per share, then that is your max profit, you are risking an infinite amount of money just to get that $1, as the stock could double or triple in that time (this happens, especially in the era of major squeezes). Therefore, you must have a sound risk control and money management strategy to record ultimate success when you use this strategy.
Naked Puts
Naked puts is another strategy that allows investors to write a put option without having a position in the underlying stock. This strategy is used when you expect the stock to trade above the strike price at expiration.It features a limited profit, limiting the maximum possible gain to the amount of premium received. Also, you can make the highest profit when the option expires worthless. In this case, you will keep all the premiums.
The risk involved in naked put slightly differs from that of naked call. For naked put, whenever the put is made against you, you will get the stock back, which allows you to hold as a part of your exit strategies. So, sometimes if you want to own a stock, but feel like it's too expensive, you can try to acquire it via stock puts. If you don't get the stock that week/month, you collect the premium you sold! If one must trade options, I think this is one of the better ways to do it. However, for high-risk traders, this may not be appealing.
Butterfly Spread
Referred to as the “butterfly option,” this is an option-selling strategy with relatively limited risks. This strategy involves the combination of different bear and bull spreads. That is, you will combine four (4) option contracts with the same expiry date at three (3) strike price points. The range of prices created by your combination can, in turn, make profits for you.This means you will sell one Put/Call option at a higher strike price and the other at a lower strike price while simultaneously buying two Puts/Calls at a strike price neat the cash price of the same underlying asset with the same expiry.
The Butterfly Option strategy works best in a market where a trader doesn’t expect high volatility of the security prices in the future. This way, you can earn some profit with limited risk. The highest loss you can record with this strategy is the initial debit you use to enter the trade and commissions. So in other words, all your losses and gains are locked in as soon as you make the trade. There will be no surprises. So if you think a stock will move 5% or 10% you can build a Butterfly Spread strategy around your thesis.
There are many variations of the butterfly spread, which are covered in incredible detail at Investopedia.
Iron Condor
Selling an Iron Condor is profitable when a stock has no significant move in either direction. It involves low volatility, extending from your purchase date to the option’s selected date of expiration.
This option-selling strategy involves selling a put and a call while simultaneously buying a put and a call. The risk associated with selling an Iron Condor is limited because of the wings' low and high strike options. The wings prevent the stock from moving significantly in either direction.
It is preferable to allow the options to expire worthlessly when selling an Iron Condor. This can only happen when the underlying asset closes between the two strike prices at expiration.
In this strategy, you might need to pay a fee to close the trade if it is successful. While the loss is limited if the trade isn’t successful, it might cost a little more than expected. Therefore, you must know how to effectively manage risk when using this strategy.
This option-selling strategy involves selling a put and a call while simultaneously buying a put and a call. The risk associated with selling an Iron Condor is limited because of the wings' low and high strike options. The wings prevent the stock from moving significantly in either direction.
It is preferable to allow the options to expire worthlessly when selling an Iron Condor. This can only happen when the underlying asset closes between the two strike prices at expiration.
In this strategy, you might need to pay a fee to close the trade if it is successful. While the loss is limited if the trade isn’t successful, it might cost a little more than expected. Therefore, you must know how to effectively manage risk when using this strategy.
The Iron Condor is used when you don't think a stock will move much, this can be applied in earnings when you think all the news has been priced in, or when you think the stock market will trade sideways rather than up/down.
Earnings Play
Earning plays feature various lucrative opportunities and higher risks from unknown elements that surround the earnings announcements. The benefits of this strategy lie in the high premium gotten every earning season for several stocks. You can also use the data of previous earnings seasons to predict the probability of winning trades' incoming earnings seasons.However, the announcements of earnings are surrounded by several uncertainties. Although these uncertainties can be very advantageous to option sellers, they also increase the risks for them. They also cause volatility in the shares. What matters the most is using the right setup before any earnings announcement.
My personal take is I don't think I've ever seen any successful consistent strategy that was able to profit from this type of play. But that doesn't prevent someone from getting lucky, or someone finally figuring it out. I think most of the money is really made in selling options on stocks trading at 52-week highs, or buying options when a stock is severely beaten down during earnings.
Selling The Volatility
Selling volatility is highly risky. It means selling options uncovered or naked. There is a fixed upside amount, also called the option’s premium, and an unlimited downside when you sell an option.In essence, while your maximum possible gain is limited, your losses are unlimited. For example, if you had sold Gamestop calls (GME) naked, you could have been in a loss amounting to hundreds or thousands of dollars (more likely even millions but you would have been margin called by then).
If you had sold a 100-strike call option for a $50 premium, and its price increased to $400, you are in for a whopping $250 per share loss. In this aspect, your huge losses could be attributed to a gamma squeeze.
Conclusion
Buying options is a losing game, however selling options as discussed above, leaves room for profitability, although at a much slower rate. It's more of a grind than winning the lottery. However, if you want to be successful, it's best to be patient.
Just a reminder, as I have mentioned countless times on this blog, through the various articles (linked below), I am strongly against options and have never really seen a strategy that truly excels at trading them.
However, despite my strong recommendation against options, hopefully, the education provided in this article will help you make more efficient trading decisions.
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