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Why sell options?

Happy Memorial Day!

music selection:  “Runaway” — Ladytron

weigh-in:  215.2 +1.0 – too much BBQ!

I recently covered my love for closed end funds (trading at a discount to NAV!) that are focused on the debt space.  Another major part of my strategy is selling options for income.  A lot of people come to options and first try to BUY options.  They see an opportunity for doubling or tripling their investment and grow blind to the very real possibility of losing their entire investment.  I’ve learned the odds are more in your favor when SELLING options.

All option pricing includes what is known as “time value”.  This time value is a wasting asset.  It declines to zero as expiry approaches.  If you purchased the option, you must overcoming this wasting effect to make money.  Even if you are right about the direction of the stock, you might lose money if the move isn’t large enough or soon enough.  When selling time value, you are guaranteed to collect the full value as an upfront cash payment by holding to expiry.

Selling options also is a great way to lower risk.  If you buy a stock outright and it declines 5%, you have an unrealized loss of 5%.  If you instead sell a put, your loss is reduced by the upfront premium received as well as any amount the put was written out of the money.  This risk reduction is a powerful but often overlooked part of selling options.

Yields get fat when the market is in distress.  This can be a great source of comfort.  When the market is taking a 50% beating, you have lost a little less and are recovering ground by the way of new positions that pay more than average as the premium written includes a volatility bonus.

Finally, the returns are repeatable and often exceed the long term average of being a buy and hold index investor.  The long term return of the S&P with dividends reinvested is between 7-9%.  Even in the current abysmal interest rate environment, I find it easy to get 12% annualized on a written put or covered call.  I often get much more.  If all you do is break even against the index, you still have win because you did it with less risk that holding the underlying equity.

Unless I roll UVXY puts, it is unlikely I will have any trades this week.  Blackstone (BX) looks to expire out of the money over the weekend.  I’ll be looking to roll it on Monday.

Devour your prey raptors!

{ 7 comments… add one }
  • Amber tree May 29, 2017, 7:07 pm

    wellw ritten on why we like to sell

  • Aaron May 31, 2017, 3:17 pm

    Have to consider short term capital gains taxes in the option selling strategy as compared to buy and hold index however. The buy and holder isn’t paying taxes each year except perhaps on the dividends.

  • Joe June 1, 2017, 6:16 am

    Do you hold some UVXY puts at this time? Learning from you I bought some when the market tanked two weeks ago and they are up over 10%. Really good so far!

  • Joe June 1, 2017, 6:23 am

    Just saw your open positions tab, sorry for asking. See the UVXY puts there.

  • Luis June 1, 2017, 12:59 pm

    Good post.

    I would add the advantages of picking stocks instead of indexes.

    Normally, option premiums are bigger in stocks than in indexes. On the other hand, every time there are good choices to pick stocks with good fundamentals; indexes include good and bad stocks, and the index can move in a very wide interval of quotes. With stocks, the picker can jump between them, as they get worse fundamentals and are replaced by better ones with high potential to boom.

    Regards.

  • Chris B June 1, 2017, 4:23 pm

    The question is why anyone buys decaying time value, if it is profitable to sell time value. To me the market’s equilibrium must have less to do with bullish speculation in long calls or people buying insurance in 30d increments with long puts at 12% a year (!), and more to do with options investors buying credit spreads so they can get more leverage with more margin. I haven’t done the math myself, but I wonder if you have. Are spreads more profitable than simple covered calls and cash-secured puts? E.g. selling lots of puts at a $10 strike and buying lots of them at the $6 strike vs. just selling a few of the $8 strike?

    • The Lizard King June 1, 2017, 6:10 pm

      Chris, that is a really good question. I don’t have an exact answer but can confidently say, “it depends”. A spread can go for both a net debit and a net credit. A net credit spread is similar to a written option except the downside is hedged away (at a cost). A net debit spread is similar to a purchased option that is partially financed by selling insurance. How profitable any strategy is has a lot to do with the current price of time value. Time value is driven by many things but primarily volatility (fear) and the prevailing market interest rate (opportunity cost).

      The reason people buy decaying time value is to gain leverage. It has a siren call for many investors. I think most investors are better off selling options and lowering their risk instead of buying them and increasing it. Your mileage may vary.

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