Selling ATM options with hedge better than selling naked OTM?

[short&naked]

Many option sellers employ leverage when selling OTM options to compensate for the low premium received. This exposes them to huge losses during market crashes.

Has anyone had success selling slightly closer ATM options which give more premium (with less leverage) during high vol periods and using some of the higher premium to by deep OTM puts to hedge tail risk?

 

[Palindrome]

Great question, I'm curious if there are other traders out there that do this often. I've never been that successful trading options.

I feel like I can only generate 7% per year selling deep out of the money, if you shoot for anything larger, you are exposing yourself to pretty large losses in my opinion.

I'm better at the futures game.

 

[TommyR]

why does it expose them to huge loses? are u saying the out the money option traders do more notional than the at the money. if not how is one more leveraged

 

[TommyR]

i think do the same thing every day regardless and let them expire u can afford more than 7% for negligible risk. ur largest single loss at 7% a year? less than 2% surely. so i guess it depends if a 4% loss for a 14% gain is not acceptable. obv the probs people have are with vega not delta and u won't have those if u do it systematically same notional every day. imo

 

[TommyR]

by the way the answer is definitely no. at the money options are much less good to sell and you make a lot less. u can check urself in excel or something

 

[beerntrading]

If volatility is worth selling, you might as well sell all of it. It's less important on higher volatility and longer-dated, because you're leaving less on the table. But calculating premium received in terms of percentage of underlying price should be the risk metric and what makes the ATMs look more appealing.

 

[TommyR]

right. so there are two volatilities the higher one is the out the money which is worth selling the lower one is not. furthermore. the literature suggests for calls and puts if we allow volatility to vary in time and space which we have to given said two volatilities the fair value of the volatility is a function of the strike and expiry so vol either being a sale or not is neither well ordered with respect to the modulus of the vol nor invariant over all contracts. from the data ive looked at crudely equating the fair price of different strikes to long term average realisations of the payouts in bs vol space, out the money put options in say spx should have a higher vol than at the money but nowhere near as high as the market price of the risk reversal often suggests. ive heard there may be possible explanations for this.

 

[Kammo]

Short&naked, it sounds like you're asking about trading vertical credit spreads with a lot of distance between your long and short options so that you get more premium for the short position and spend less on the long position than you would if the gap between the long and short positions were closer. You're also contemplating choosing short positions that are close to being in the money for the sake of getting premiums that are higher than premiums on short positions that are farther out of the money. Regarding trading wider credit spreads, there are two problems. First, you have to put up more collateral, or requirement, or whatever your broker calls the money you have to set aside to protect the broker should your spread become a loser. You might be better off splitting that extra collateral between two credit spreads instead of dedicating it to just one credit spread. Second, the wider spread increases your potential loss. With regard to choosing short positions that are closer to being in the money for the sake of higher premiums, you will be amazed at how your rapidly developing loss on near ATM short positions will dwarf whatever premium you might have received, even though the premium was relatively high. I believe you're better off setting up tighter credit spreads farther out of the money and just setting up a lot of them to compensate for the lower premiums they earn.

 

[short&naked]

Short&naked, it sounds like you're asking about trading vertical credit spreads with a lot of distance between your long and short options so that you get more premium for the short position and spend less on the long position than you would if the gap between the long and short positions were closer. You're also contemplating choosing short positions that are close to being in the money for the sake of getting premiums that are higher than premiums on short positions that are farther out of the money. Regarding trading wider credit spreads, there are two problems. First, you have to put up more collateral, or requirement, or whatever your broker calls the money you have to set aside to protect the broker should your spread become a loser. You might be better off splitting that extra collateral between two credit spreads instead of dedicating it to just one credit spread. Second, the wider spread increases your potential loss. With regard to choosing short positions that are closer to being in the money for the sake of higher premiums, you will be amazed at how your rapidly developing loss on near ATM short positions will dwarf whatever premium you might have received, even though the premium was relatively high. I believe you're better off setting up tighter credit spreads farther out of the money and just setting up a lot of them to compensate for the lower premiums they earn.

This is exactly what I had in mind. I wanted to buy long positions such that they would insure against violent moves, not slow moving declines which I take it could be protected against by rolling short positions?

 

[Kammo]

Rolling won't necessarily or automatically protect you. It might even compound your losses. By the way, when I said that you're better off setting up tighter credit spreads farther out of the money and just setting up a lot of them to compensate for the lower premiums they earn, I should have added that one way to earn more premium is to try to set up a decent iron condor instead of a simple credit spread when you believe that the underlying will stay within a certain range. It's not always possible to set up a decent iron condor, though. The puts or the calls that you need for the other two legs on the iron condor might be too cheap.