Selling “Expensive” Option Premium

Long before weekly options were a thing when ticks were still in 16ths, and we downloaded batches of chart data over a dial-up modem…  I “discovered” the world of options.

Like most options newcomers, I first learned about buying options – either Calls or Puts – to hopefully profit in a directional move of the underlying stock.   I’d buy Calls to profit from an increase in the underlying’s price and Puts to profit from a decrease in the underlying’s price.  Simple, yes?  (Okay, maybe there’s a bit more to it than that.)

And soon after, I learned about selling options – about how I could “outsmart” the market by being a seller of options rather than a buyer.   Ah, those were the days — of option-selling thrills and sudden “learning experiences”.

If your objective is steady, repeatable income, option selling strategies can work well.  Selling options rather than buying does have advantages.  As theta time decay works in favor of the option seller, premium sellers tend to have a higher probability of a profit.  The tradeoff is that the profit is limited to the amount of net option premium collected.

Selling options – Puts or Calls – also comes with a potential obligation to either provide or buy the stock at the option strike price.  Those obligations could present substantial risk depending on the underlying stock, implied volatility, position size, and how the trade is structured.

Being the “smart” young trader I was, I soon realized I could look for stocks with very high option premiums and focus on selling those.   My trading platform even made it easy to create scans based on high implied volatility to find them.

It’s not hard to find extreme option premiums on small stocks.  Quite often, there is a pending big news event.  For example, a small pharmaceutical company that has its only product in trials and has FDA approval pending.  In a situation like that, where the company’s whole future could be riding on approval news, we’re likely to find astronomical option premiums.   Don’t be tempted.

What could possibly go wrong?  If the approval falls through for some reason, the entire company could be out of business in short order.  And option sellers can be left “holding the bag.”  It happens.

There are no giveaways in the options market.  When premiums are high, they are high for a reason.   When we buy options, we have risk up to the amount of premium paid.  When we sell options, we could have a much greater risk of buying soon-to-be-worthless shares at the strike price.

Here are some tips for selling option premium…

Avoid Illiquid Product

If you see a stock with very thinly traded options, take it as a warning sign.  If you want steady, consistent results, stick with larger, more well-known stocks with good liquidity.  I regularly look at S&P 500 and Nasdaq 100 stocks for candidates.  That’s an excellent place to start when looking for premium-selling opportunities.  Stocks with weekly options, and reasonable participation in those options, tend to be better candidates.

When there’s good liquidity in the options, you’ll see decent volume and open interest across a range of strike prices and expiration dates.  These options should have narrow bid/ask spreads, sometimes as little as a penny wide.  You can get in and out of trades or extend duration by rolling at fair prices.

When the bid/ask spreads are extremely wide, it could be just you vs. the option Market Maker.  Option Market Makers are the buyers/sellers of last resort.  Market Makers generally hedge their directional risk as their core business is to make money not from directional moves but rather from the bid/ask spreads.  So, if it’s just you and the Market Maker trying to agree on a price, don’t expect any mercy.   Market Makers have kids to get through college too.

Avoid Extreme Premiums

Learn to recognize when premiums are extreme.  The implied volatility will be high versus the historical volatility.   When premiums look too good to be true, look closer.  There is always a reason.

This is not to say you can’t sell expensive option premium.

But, for example, don’t sell Puts on more stock than you’re willing to own.  Even if the stock goes to $0.

Five Rules for Option Sellers

1. Adopt a long-term mindset.  We want our option selling strategies to be repeatable and sustainable, so we can stay profitably “in the business” for the long term.

• Don’t sell premiums on the hottest stocks you can find just because the premiums are huge and tempting.
• On any trade, mind your position size.   If the stock makes an outsized move or even goes to $0, will you be able to shrug off the loss?  Size accordingly.
• Always understand your worst-case risk.   Stock prices can do things that we thought very unlikely when we opened the trade.
• Trade liquid products.  I can’t emphasize enough how important it can be to get fair prices when buying, selling, or rolling.  We don’t want to start our trades with the distinct disadvantage of not being able to get “fair” prices.

Want to Learn More About Options Trading?

Every day on Options Trading Signals, we do defined risk trades that protect us from black swan events 24/7. Many may think that is what stop losses are for. Well, remember the markets are only open about 1/3 of the hours in a day. Therefore, a stop loss only protects you for 1/3 of each day. Stocks can gap up or down. With options, you are always protected because we do defined risk in a spread. We cover with multiple legs, which are always on once you own.

If you are new to trading or have been trading stock but are interested in options, you can find more information at The Technical Traders – Options Trading Signals Service. Brian, who has been trading options for almost 20 years, sends out real live trade alerts on actual trades, such as TSLA and NVDA, with real money. Ready to subscribe, click here:  TheTechnicalTraders.com.

Enjoy your day!

Chris Vermeulen
Founder & Chief Market Strategist
TheTechnicalTraders.com