Table of Contents
Introduction
In the world of financial markets, big players often engage in complex strategies to maximize their profits. One such strategy involves selling options in the futures and options market. In this article, we will explore how these big players win by selling options.
Understanding Options
Options are financial derivatives that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specified time period. When big players sell options, they are essentially taking on the role of the option seller or writer.
Generating Income
One of the main reasons big players sell options is to generate income. When they sell options, they receive a premium from the buyer. This premium is their immediate profit, regardless of the outcome of the option contract. By selling options repeatedly, big players can accumulate significant income over time.
Probability of Profit
Another advantage of selling options is that big players can increase their probability of profit. When they sell options, they are essentially betting that the price of the underlying asset will not reach a certain level (in the case of selling call options) or will not fall below a certain level (in the case of selling put options). Since most options expire worthless, big players can profit from the time decay and the statistical probability of the options expiring out of the money.
Reduced Risk
Selling options can also help big players reduce their risk exposure. When they sell options, they are not exposed to the same risks as the option buyer. For example, if they sell a call option, they are not obligated to deliver the underlying asset if the buyer exercises the option. Instead, they keep the premium received and the option expires worthless. This allows big players to limit their potential losses and control their risk.
Flexibility and Control
By selling options, big players also gain flexibility and control over their positions. They can choose the strike price and expiration date of the options they sell, allowing them to tailor their strategies to their specific market outlook. This flexibility and control give them an edge in the market and increase their chances of success.
Options Trading Rules or Fundamentals:
A set of trading fundamentals must be followed to successfully run an options based portfolio. Specifically, position sizing, sector diversity, maximizing the number of trade occurrences, levering IV Rank and risk defined strategies are some notable areas that traders need to heed for long-term successful options trading not only in small accounts but in accounts of all sizes. The stock options screening software is a valuable supplement to identify trades through a range of stocks.
In order to effectively and successfully run an options based portfolio over the long term, the following option trading fundamentals must be exercised in each and every trade. Violating any of these fundamentals will jeopardize this strategy and possibly negate the effectiveness of this approach on a whole. Below are option trading rules for small accounts and accounts of all sizes but specifically small accounts as it pertains to risk defined strategies when capital is limited.
- Spread out expiration dates to avoid expiration density. Spreading options exposure over the course of each month reduces options specific risk at any given expiration date. Stocks tend to auto-correlate when markets experience dramatic moves and may jeopardized certain option trades that are in play at the time of these sharp market moves. To mitigate this risk, option expiration dates should spread out various expiration dates.
- Sell options in high IV Rank environments to extract rich premiums. Selling options when IV Rank is high provides an edge for option sellers. Since implied volatility is historically overestimated, when IV Rank is high, this provides rich option premium income. When the underlying security fails to be as volatile as predicted, the implied volatility will fall along with the value of the option. When implied volatility reverts to its mean in conjunction with time decay, the option can be closed out for a realized gain.
- Sell options on symbols or stocks that are liquid in the options market. Options must be liquid so option traders can easily and readily buy and sell contracts. Liquidity is essential for tight bid/ask spreads so accurate options pricing can be obtained.
- Maximize the number of trades to allow the expected probabilities to play out. Given enough trade occurrences over various market conditions at any given option delta, the expected probabilities will reach their predicted outcomes. Using a coin toss analogy, flipping a coin 10 times, 100 times or a 1,000 times will result in different outcomes however the more attempts, the closer the 50:50 expected outcome will be achieved.
- Appropriate position sizing / portfolio allocation to manage risk exposure. For any well balanced portfolio, no more than 20%-30% of the portfolio should be exposed to options. Any given trade should not constitute more than 1%-3% of the portfolio in order to appropriately manage risk. The number of contracts should be scaled to ensure risk is well managed and not opening up the portfolio for significant drawdowns.
- Sell options across different stocks with ample sector diversity. Sector diversity is essential in order to manage risk as certain sectors or industries can auto-correlate and move in the same direction. In order to mitigate several option trades potentially being jeopardized, options need to spread over dissimilar sectors
- Set the probability of success (options delta) in your favor with 70%, 85% to ensure a statistical edge. Delta is a proxy for probability of success at expiration of an option contract. Provided enough trades throughout various market conditions at a specific delta, the probabilities will play out to align with the delta. For instance, targeting a delta of 0.15 on strike ensure written with 85% probability of success, given enough trades over time, a win percentage of ~85% will be obtained.
- Manage winning trades by closing the trade and realizing profits early in the option lifecycle.Proactively managing winning trades is essential to maintain a high win rate and avoid any potential of the trade moving against you in the latter stage of the expiration cycle. If the premium capture is greater than 50% of max profit, closing out the trade and realizing profits is highly recommended as opposed to allowing the option to expire worthless. This closure will realize profits early and free-up the capital for subsequent trades.
- Sell options in high IV Rank environments to extract rich premiums. Selling options when IV Rank is high provides an edge for option sellers. Since implied volatility is historically overestimated, when IV Rank is high, this provides rich option premium income. When the underlying security fails to be as volatile as predicted, the implied volatility will fall along with the value of the option. When implied volatility reverts to its mean in conjunction with time decay, the option can be closed out for a realized gain.
- Keeping an adequate amount of cash on hand for covering loss. Making positions. Keeping a large amount of cash on-hand is necessary as a mitigation factor and to allow opportunistic purchases of long equity to balance out the portfolio. An options-based portfolio is a holistic approach and long equity positions is an essential anchor.
- Risk-defined trades (put spreads, call spreads and iron condors). All trades need to be risk-defined in order to limit overall risk and leverage a minimal amount of capital. Undefined risk trades are capital intensive with unlimited risk.
Conclusion
Selling options is a winning strategy employed by big players in the futures and options market. It allows them to generate income, increase their probability of profit, reduce risk, and maintain flexibility and control over their positions. However, it is important to note that selling options also carries risks, and proper risk management is crucial for success in this strategy.