Most people make money when the market trends. And we know that market doesn’t trend most of the time. Side-way markets are boring and traders felt devoid of profits. One of the ideas to trade a side-way market is to sell options. WRONG! To me, this is the worst time to sell, unless it is a covered call. Selling options during a quiet market is courting death, and that is why most traders warn against selling options in general.
Let me explain.
3 Main Factors of Option Pricing
Those who are not interested in options are unlikely to have read the article to this point, and if you did, I assume you have some knowledge about options and I am not going to repeat what other sites have been explaining about the basics. I will just go through a truncated explanation.
Time Decay (Theta)
The natural advantage going for the option seller is time decay. All options have an expiry date and the option premium will reduce day by day if other factors are kept constant.
Underlying Price Movement (Delta & Gamma)
Second element of option pricing is commonly known as the intrinsic value, measured by the price difference between the underlying price and strike price. The option will be more expensive when the underlying price is moving closer to the strike price, and the contrary is true.
Third element is volatility. In a side-way and quiet market, volatility is low and option premium is cheaper, with all other factors being equal. When the underlying price moves wildly, volatility increases and will be priced into the option premium.
Interest rates and dividends are less significant in affecting option premiums. There aren’t dividends for commodity options at all.
When to Sell or Short an Option (and when not to)
When you sell options, you want the option premium to decrease. The best time to sell an option is to counter a trend. Yes, not follow the trend or in a side-way market.
When an underlying is rising in price, the call options will become more expensive. When the underlying is falling in price, the put options will become more expensive. In addition, the volatility has also increased, leading to higher option premiums. The mantra to successful investing is to buy low and sell high, or sell high and buy low. Hence, shorting (selling) high option premiums is a logical point of entry, and usually counter trend has high option premiums.
(I must clarify that traders may view trends differently because of a time-frame difference. My time-frame of trend is the price direction in the past 1-2 months.)
It is less lucrative to sell a put option when the underlying is rising in price, or sell a call option when the underlying is falling in price. It is mistakenly perceived as safer than a counter trend trade. To me, it is riskier because the option premium is likely to be lower and have the potential to become more expensive when the market changes direction.
Another misconception is selling options during a side-way market. Most traders need price movements to make money. Side-way markets are boring and traders yearn for profits during the quiet times may resort to selling options. This is the most risky time to sell options. This is because options prices are cheap due to low volatility and the option prices would jump when the market starts to move, amounting to losses very quickly.
In essence, sell options when they are expensive, and avoid selling when options are cheap. Wait for the market to make a move and we react. Do not predict and make a move first, because other traders may react against you. Sun Tzu has a wise saying for traders:
“The opportunity to secure ourselves against defeat lies in our own hands, but the opportunity of defeating the enemy is provided by the enemy himself.”
Margin, Margin, Margin
The problem with selling options is that the broker will require you to put up a high margin. And to make things even more complicated, this initial margin is not fixed and will increase correspondingly with the increase in options price. Hence, maintaining sufficient margin in your trading account is of utmost importance. Trade small. You are not trying to make a fortune with selling options. It doesn’t matter whether you are right on your trades, but whether can you survive till the trades are closed. John Maynard Keynes said,
“The market can stay irrational longer than you can stay solvent.”
You may not always be right with the counter-trend trades and sometimes, the trend can be stronger than it appears to. Hence, there will be times when the trader must take the loss and close the position. The problem with selling options is that an automated stop loss order cannot be used. It requires manual closing and because of that, it requires much more discipline to overcome the emotions of loss aversion. To me, this is the most risky element of options selling. The first part of Sun Tzu quote is so true, “The opportunity to secure ourselves against defeat lies in our own hands…”
Co-Founder. Believer of the Factor-based Investing approach. Running a Multi-Factor Portfolio that taps on the Value, Size, Profitability and Momentum Factors. Quant at heart. Believe the financial industry can treat their customers better. Wants to change the world.