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Swim in the Deep End with Out-of-the-Money Options

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May 14, 2015
Consider diving into the pool with out-of-the-money options

Sometimes higher potential stock returns and lower volatility are swimming in the same pool. However, selling out-of-the-money options has the potential to put them in the same lane. That’s because the premium gained from selling options can potentially supplement your portfolio’s returns. And, unless large price swings in the underlying securities occur, out-of-the-money options don’t change a lot, except to allow time value to decay.

This means you could consider a swim in the options market’s deep end and not even need your floaties. Although, make sure you take your snorkel. After all, options do carry additional risks beyond stock-market risks; they're not for everyone.     

Security Selection

When contemplating this approach, you could consider selling options -- like covered calls -- on stocks and exchange-traded funds (ETFs) in your portfolio if they are highly liquid, meaning they have a lot of options to trade. Or, you could sell vertical spreads on liked securities that you don't own.

You can often identify these options by the bid/ask spreads in the option chains (figure 1). 


FIGURE 1: START YOUR SEARCH. Explore regularly traded, out-of-the-money options by viewing the bid/ask spreads in option chains. For illustrative purposes only.

Option Selection

One approach is when short, go short. That means keeping the expiration short, like, 50 days from expiration. The closer to expiration, the faster the time value will melt. Next, consider selling calls and puts with a probability of expiring out of the money between 60-70%. A probability calculator can be used to help determine which options may fit within these guidelines. Typically this would translate into options that have a delta between 30 to 40 for calls or -30 to -40 for puts.

Protection Selection

Finally, if you're selling covered calls then you're already protected if the stock rallies and your call is assigned. You'll be able to deliver your shares to fulfill the assignment. However, if you're selling vertical spreads, you'll need to buy an option that you can use as a degree of short-term protection. For example, if you sell an out-of-the-money call, buy a further out-of-the-money call. This way, if a large rally occurs and your short call is assigned, you may be able to exercise your long call and limit your losses on the trade.   

Once you’re comfortable learning the concept of selling out-of-the-money options, it could become part of your routine. You could consider closing, adding, or rolling new options each month. 

Not an Exact Science. But Close.

Although not perfect, determining probabilities can help you evaluate a trade’s possible outcomes and your comfort level with those outcomes. 

NC
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