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Rethink Options: Aim for Income by Embracing Market Inaction

November 24, 2015
Try these these strategies for options income trading.

Option income trading doesn’t have to involve a big stance on market direction. Certain option strategies bank on the fact that the stock market might not move much at all during a certain time period. Embracing market inaction can mean that a trader forfeits a potential win from a big move, but it can add income pursuit to most stock trading strategies.

The stock market is typically assumed to move up and down, potentially significantly. Traders might go long if they think there is substantial upside potential. Or they might go short because they expect the broader market (or a particular stock) to fall for at least some amount of time. Of course, they will eventually have to buy back the shares, hopefully at a lower price than they were sold at. The amount of volatility in the market helps determine how fast stocks might move in a given direction.

Option income strategists may care less about direction, although they care plenty about time (more on that below). Simply put, these income-aiming strategies can succeed when the market doesn’t move that much; they can also disappoint when the underlying makes a huge move.

Two Types of Income Strategies

Option income strategies can be split into two general categories. The first is based on direction—an assumption that the market will move, and will move in your favor. This might include put or call sales, vertical spread sales, and other strategies. Covered calls are another potential income generator based on directional strategies. (Please note that a covered call strategy will limit the upside potential of the underlying stock position, as the stock would likely be called away in the event of substantial stock price increase, but you can read more about that in the article link.)

Secondly, there are non-directional income strategies. Their alias: delta-neutral trades. Delta measures market change. By design, traders attempt to inoculate their position from sharp market movement and instead look to profit from option premium decay over time. Option prices are primarily affected by the difference between the stock price and the option strike price, the time remaining before the option expires, and the volatility of the underlying stock, along with other factors. Option premium is the price of an options contract paid to the seller of the option. And, voila, that’s the income piece we’re talking about. 

Why This “Conservative” Approach?

Traders should never rule out having to make adjustments and they should always be vigilant, but income strategies are designed to limit the amount of total trades, a potential transaction-cost saver.

Income strategies can also be a time-saver. How? Active stock selection is typically not part of this routine. Raising the odds of success typically hinges on focusing on the same assets over and over, often equity indices and select liquid stocks. Maybe you’re not a full-time trader? This strategy may fit in with a busy schedule.

Proponents will argue that income trades can complement other directional trade strategies. For example, a trader could couple income trading with a separate, trend-following strategy. If the market breaks out into a new trend, the income trades will likely underperform, but the directional trade could pay off. What’s more, if market action “stops out” a trend-following strategy, the income trades can potentially cushion losses.

It’s Still Speculation

Income strategies are designed to make money when markets are range-bound, so when putting on these trades you are essentially speculating that the market will stay within a certain range for a period of time. That’s still speculation.

You will be exposed to risks commonly referred to as “the greeks.”

Option traders utilizing these strategies have to manage market delta until theta kicks in. The main risk is the short gamma of the position. That means movement in the underlying will increase directional risk—your delta—and there could come a point in time where that risk becomes too high; you’ll need to adjust to save the trade. This is known as “delta-band” trading, where you have an acceptable directional exposure. The lesson: Mind your greeks.

So-called income trades have nuances just like any market strategy, but for teaching purposes they tend to track three basic structures. We’ll lean on The Ticker Tape article archives to help highlight this trio:

Condors. Many option traders will argue that this trade makes sense when the implied volatility skew is very high, meaning out of the money options grow in interest. Iron condors involve a short call vertical spread combined with a short put vertical. Read more on this strategy.

Butterflies. Many option traders will insist this trade works best when realized volatility continues to stay low, but volatility skew is no longer steep. The strategy is covered in Tom White’s RED Option Strategy of the Week, a fixture in our Volatility Update column.

Calendars. Many option traders will typically encourage this strategy when implied volatility is very low. Because it’s long a back-month option, it’s the only income trade structure that’s net long vega (the greeks again), which means if implied volatility rises, the trade stands to benefit. Here’s Tom White again with a deeper study.

Iron condors, butterflies, calendar spreads and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return. These are advanced option strategies and often involve greater risk, and more complex risk, than basic options trades.

Option trading isn't suitable for everyone. These strategies and their potential benefits and risks should be understood completely before any trades are placed. 

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