So many trader prefer options plans that involve being a net seller of premium. This approach allows them to spend less time managing the trade, more room to be wrong on the direction of the underlying, and best of all, they don’t need a large account to sell. In this written article, I wish to speak about a a couple of my favorite premium selling strategies and give some brief points on how to sell them with a nominal amount of time investment.
Overview of options spreads
Before jumping into a discussion of the tactics, let me give a brief overview of options spreads. The basic idea of a spread is to purchase one option and sell another against it. This usually has the advantage of making a defined risk position but delivers the almost limitless profit potential of simply buying an option outright. Variations on spreads include vertical spreads where I purchase one option strike in a given month for a particular underlying and sell another alternative in the same month and same underlying. Calendar spreads involve buying an options strike in 30 days for a given underlying and selling an option of the identical strike price and same underlying but in a different month.
How do premium selling plans work
My favorite strategy is the short vertical spread, where I sell an alternative close to the current trading price of the underlying and purchase a strike price farther away from the actual price than the strike I sold. This trade is put on for a credit and the risk is bound to the dollar difference between my short and long strike prices minus the credit I received. The maximum amount of profit in this trade is the credit I receive from selling the spread. I will get to keep this credit on expiration if the short strike expires out of the cash by $.01 or more.
Why is this my favorite strategy? Let me use an example to illustrate. For example that SPY, currently trading at $108, has been in a bullish trend recently and my near term (20-40 day) forecast is for SPY to go up more or move sideways. A vertical spread trade I may put on is to trade a put option on SPY at $104 for a month with 20-40 days left until expiration and purchase a put option at $102. This is a $2 wide spread and can be put on for $.50, which signifies my risk in the trade is $1.50. For one contract, it will definitely cost me $200 in margin and my max risk is $150.
Once the trade is on, what are the possibilities? SPY can move up strongly and within a week I could close the trade for $.10 debit locking in $.40 gain and an ROI of 26%. However, SPY could also go sideways for the following month or even pull back a few dollars. In all of those cases my trade still makes money. Why is that? Because I have sold an out of the money option that is 100% time premium with no intrinsic value. In a case like that, time is my friend. While it’s true I also own a long put option that is in addition wasting away, it’s value was firstly less so if both expire worthless, I finish up with a net credit.
Making a trading plan
It’s not enough to simply know about the strategy. To be prosperous in the long run, I have to have some consistent rules I follow that dictate when to get into a trade, when to get out and how much risk to assume on each trade. These rules together are a key section of an alternative trading plan. I have one for this strategy, which I’ll briefly outline.
I trade both bullish and bearish short verticals. For this discussion, I’ll talk just about the bullish trade and leave the bearish as a workout for the reader.
Outlook: Trade this strategy on an underlying (usually an ETF) with an established bullish trend (higher highs & higher lows)
Market Entry Points: Look to penetrate a trade on options with 20-40 days remaining until expiration and I try to sell a few strikes out of the money on the short strike. I also prefer $2 wide spreads as the margin requirement and risk are easily managed
Market Exit Points: I have at least one ideal profit target and one ‘worst case’ scenario known as exits. An easy one for me is what I call the 20%/100% rule. I will exit when regrettably you can only use 20% of the initial credit left in the trade. I will also exit if the cost to shut has grown by 100%. To Illustrate, if I put on the trade for $.50, then my ideal exit would be to shut for $.10 (20% rule), while my ‘worst case’ exit would be $1.00 (100% rule).
This is obviously a very easy trading plan that needs some more definition but provides a reduced maintenance approach to option trading. With numerous options trading platforms, I am in a position to enter my exit rules as a ‘one-cancels-other’ order where both orders are entered and when one triggers to fill, the other is cancelled. That’s it – no muss, no fuss.
More strategies
Another strategy I like when I’m more neutral is what is called an iron condor. That’s when I sell both a short call vertical and a short put vertical on the same underlying for the same month. Usually with a $2 wide spread, I’ll have at least $4 between the short put and the short call. So on the SPY position I mentioned, that can be a $114/112 call spread and a $104/102 put spread.
The benefit of this strategy is that it is able to receive twice the premium with the same amount of risk. Consider it. On expiration, is it feasible for SPY to both be above $110 AND below $104? No. So, most brokerages will only hold margin on one side for this type of trade.
Another strategy I like is a calendar spread. I may purchase a $104 put several months out on the SPY and then sell a $104 put out 20-40 days until expiration. This is in reality a debit spread but is still considered a premium selling strategy. It’s a little longer term strategy but can pay very well.
These are my bread and butter trades. I am in a position to trade them regardless of what the market is doing and they keep on do well for me.
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