Looking to supplement returns? Consider selling out-of-the-money options. Unless there are large price swings, these options don’t change much.
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.
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.
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.
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.
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A covered call strategy can 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. Additionally, any downside protection provided to the related stock position is limited to the premium received.
The cash secured put strategy risks purchasing the corresponding stock at the strike price when the market price of the stock will likely be lower.
The risk of loss on an uncovered call option position is potentially unlimited since there is no limit to the price increase of the underlying security. The naked put strategy includes a high risk of purchasing the corresponding stock at the strike price when the market price of the stock will likely be lower. Naked option strategies involve the highest amount of risk and are only appropriate for traders with the highest risk tolerance.
Maximum potential reward for a credit spread is limited to the net premium received, less transaction costs. The maximum loss is the difference between strikes, less net premium received, plus transaction costs.
Multiple leg options transactions will incur contract fees on each leg.
Market volatility, volume, and system availability may delay account access and trade executions.
Past performance of a security or strategy does not guarantee future results or success.
Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.
Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.
The information is not intended to be investment advice or construed as a recommendation or endorsement of any particular investment or investment strategy, and is for illustrative purposes only. Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
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