Seasoned option investors ready to step up their game may look to the advanced strategy of selling options, says author James Cordier. These investors are odds players, hoping to pocket premiums with smaller-horizon moves that can trim the risky time exposure facing option buyers. Of course, selling options carries unique opportunities as well as significant risks and are only suitable for the most seasoned traders with the highest risk tolerance.
The Ticker Tape sat down with Cordier, co-author of The Complete Guide to Option Selling, for his opinions and insights on the strategy.
Ticker Tape: Let's start with the basics—talk about buying options.
Cordier: When you buy an option, you pay a premium to own that option. If the underlying stock or commodity moves beyond your strike price, you can either sell or exercise your option, hopefully at a profit. If you get a huge move in your favor, you can potentially turn your small investment into a big gain. And your only risk is the premium you paid.
Ticker Tape: Sounds great. What are the downsides?
Cordier: Most out-of-the-money options will stay out of the money and expire worthless. Like a lottery ticket. An option buyer not only has to predict a big move, he has to have almost perfect timing—time value is working against him from day one.
Ticker Tape: OK, so how does option selling differ from option buying?
Cordier: Option sellers collect premiums from buyers. When the options expire worthless, they keep those premiums as profit. Sellers avoid the difficult game the option buyers are playing and simply focus on odds. They don’t care what the market is going to do, only what it’s not going to do. It’s almost the exact concept used by insurance companies. Like an insurance company, option sellers accept the risk of a sharp move against their position, which could cause them a loss. But unlike an insurance company, they can close out their position at any time.* An option seller gives up his or her chance to hit “home runs” in exchange for hitting singles over and over again.
*TD Ameritrade disclosure: There is no guarantee of a secondary market for any option.
Ticker Tape: What is a risk the option seller might face?
Cordier: That the underlying moves against the option seller’s position, causing the option to increase in value. If an option is increasing in value, the seller of the option is losing money. Detractors of option selling love to point out that option selling has unlimited risk. This is true, but taken substantially out of context. If you are short a call—just like being short a stock—there is no limit to how high the market can go, so your risk is unlimited. What this really means is that you have to manage the risk yourself by using stops, credit spreads, or other means. Stops can be entered in options, just like when buying or selling a stock.
Ticker Tape: How do you identify opportunities for selling options?
Cordier: Look for markets with clear long-term fundamentals. Bullish or bearish doesn’t matter. As long as you have longer fundamentals that favor one side, you can sell options on the other side. Don’t get caught up in short-term trading, or trying to time moves. Option selling is about the long game. Focus on the longer-term fundamentals and the picture can become clearer. This is what the short-term traders overlook.
Ticker Tape: Any mistakes that you see a lot?
Cordier: I think a big mistake that new option sellers make is getting caught up in all the greeks and thinking they have to learn all of these formulas to be successful. Obviously, it helps to have some volatility to drive up option values. But don’t put too much of your focus on pure volatility. Putting option volatility ahead of the fundamentals of the underlying stock is putting the cart before the horse.
Ticker Tape: Any last thoughts?
Cordier: Be willing to trade in time for distance. Be willing to accept a little more in time value to be able to sell further out-of-the-money options. Deep out-of-the-money options tend to stay deep out of the money. That means worthless expirations. As an option seller, that’s what you are looking for.
Transaction costs (commissions and other fees) are important factors and should be considered when evaluating any options trade.
Spreads and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return.
James Cordier and TD Ameritrade are separate and unaffiliated. TD Ameritrade is not responsible for any third-party content or opinions presented.