Strategy: Selling Put Options: The Best Income Method?

[yobo]

You're right. There are many ways to trade. Some trade deltas. Some trade vol. Some are a mix bag. Some trade forex. Some futures. Some options. Whatever is your forte.

Regarding probability of a certain strike being ITM or not. How does anyone know? It ultimately goes back to price projection and trying to predict what the market will do. What is a high probability trade? If a stock drops 40%, then you can sell puts because it's less likely to fall after a huge gap like that? What is the rationale?

Also, why selling of options? If you can reasonably project where prices may or may not go, why not directly bet on the underlying? More profit that way. I guess the advantage to selling options OTM is larger 'margin of safety' and so it seems 'safer' than betting on underlying, because there is a huge cushion before you get 'into trouble'.

Part of the pricing model with options includes IV or implied volatility with a certain period of time. It doesn't predict direction of price, but gives you a theoretical value of where a stock price will be. When you overlay a normal distribution curve you can apply probabilities to where the stock price will be. 1 standard deviation implies the price will fall within a range 68% of the time. 2 standard deviations implies a price will fall within that range 95% of the time. So for example, a stock trades at 100 and 1 standard deviation equals 10 and two standard deviations equals 20 for a time period of one week. According to theory and normal distributions, the stock will trade between 90 and 110, 68% of the time. And, between 80 and 120, 95% of the time. If you believe these numbers because again they are theoretical based on the options pricing model, one can place high probability trades based on these parameters. If I sell a put that is just outside the two standard deviation mark away (Example: 79 strike price) from its price, I have a 95% chance of that put expiring worthless and a 5% chance of being wrong.

If a stock drops 40% as you mentioned in your example the implied volatility will spike and options become more expensive and the premium you can collect is greater. If the market anticipates a 40% drop, the option will price it in. Traders like you and I however will get into trouble if we are selling options and the option price doesn't reflect the drop and surprises the market. This is why you often hear people say sell options when the IV is high and buy options when the IV is low in anticipation of IV either increasing or decreasing.

 

[just21]

Why is everybody obsessed with the stock market when the bond market is twice as big?

https://www.fool.com/knowledge-center/5-bond-market-facts-you-need-to-know.aspx

 

[yobo]

The whole sell covered calls after being assigned thing is funny because it's just more put selling but this time with a synthetic short put (S = C - P => S - C = -P). The entire strategy is another bull market genius story of selling puts and basically everything going great until one day market context changes and it stops going great.

Also far OTM is not necessarily safe. If it were so safe we'd all be selling delta 5 options a 1000 times over and loading up the bank account (which clearly won't happen in the long run). I'd rather not sell things that explode in value if any number of random swans show up.

IMO you're much better off selling ATM straddles - atleast then you can get out alive because you won't need to juice the hell out of things to get a decent premium and also have gamma working for you not against you.

However were at almost record low VIX again so why be short volatility into that?

If you are trading the index than yes selling volatility when it is historically low doesn't make sense. But there are a ton of stocks with high enough IV to make selling puts worthwhile.

From my perspective selling ATM straddles is even more risky because you initiate a position that can go terrible wrong in one of the two directions. Gamma will only work for you on one side of the trade if the security suddenly takes a nose dive or spikes higher. If a sudden move occurs, you will be forced to adjust your trade by either turning your short put or short call into either a debit or credit spread to minimize your losses.

I personally can not make those decisions fast enough on weekly expirations but if you can than go for it.

 

[beefcaketrade]

The whole sell covered calls after being assigned thing is funny because it's just more put selling but this time with a synthetic short put (S = C - P => S - C = -P). The entire strategy is another bull market genius story of selling puts and basically everything going great until one day market context changes and it stops going great.

Also far OTM is not necessarily safe. If it were so safe we'd all be selling delta 5 options a 1000 times over and loading up the bank account (which clearly won't happen in the long run). I'd rather not sell things that explode in value if any number of random swans show up.

IMO you're much better off selling ATM straddles - atleast then you can get out alive because you won't need to juice the hell out of things to get a decent premium and also have gamma working for you not against you.

However were at almost record low VIX again so why be short volatility into that?

Selling a covered call above your cost basis allows for upside. It is the synthetic equivalent of selling a ATM or ITM put.

The difference with the guy's strategy of selling OTM puts, is that being OTM allows for 'some' degree of error, should the market move against you by falling, you still have a chance of walking out with a gain and not taking a hit, despite the market falling. Whereas, if you sold an ITM put, you are licking your chops right away if the market falls. So there is an advantage to selling OTM put vs just ITM or ATM puts.

I agree in general that put selling, as has been said many times before, is like picking up pennies in front of a freight train. Still, it offers people the 'opportunity' to win.

I don't think short straddles are intrinsically advantageous as you can get cleaned out just as well if the market makes big moves. Although it is true that going further OTM for options selling means there is a tendency for traders to makeup for smaller premium by multiplying risk exposure, which might end up hurting more when market moves against them. But ultimately there is an investment thesis, and there is a market 'prediction' and you bet accordingly.

 

[beefcaketrade]

Part of the pricing model with options includes IV or implied volatility with a certain period of time. It doesn't predict direction of price, but gives you a theoretical value of where a stock price will be. When you overlay a normal distribution curve you can apply probabilities to where the stock price will be. 1 standard deviation implies the price will fall within a range 68% of the time. 2 standard deviations implies a price will fall within that range 95% of the time. So for example, a stock trades at 100 and 1 standard deviation equals 10 and two standard deviations equals 20 for a time period of one week. According to theory and normal distributions, the stock will trade between 90 and 110, 68% of the time. And, between 80 and 120, 95% of the time. If you believe these numbers because again they are theoretical based on the options pricing model, one can place high probability trades based on these parameters. If I sell a put that is just outside the two standard deviation mark away (Example: 79 strike price) from its price, I have a 95% chance of that put expiring worthless and a 5% chance of being wrong.

If a stock drops 40% as you mentioned in your example the implied volatility will spike and options become more expensive and the premium you can collect is greater. If the market anticipates a 40% drop, the option will price it in. Traders like you and I however will get into trouble if we are selling options and the option price doesn't reflect the drop and surprises the market. This is why you often hear people say sell options when the IV is high and buy options when the IV is low in anticipation of IV either increasing or decreasing.

You're putting too much stock on efficient market hypothesis.

IV is not a predictor of future outcomes. It is ultimately at the core merely a reflection of market participant expectations in the options market.

Look at the VIX. Was at historic low levels weeks ago. Now it's way high. If you looked at what options told you weeks ago, it would have told you the sell off was 'improbable'. Yet here we are today.

I don't think it's a fool proof strategy to look at IV and then inferring some market move expectation and its likelihood. IV has a lag. It doesn't look like volatility will be high, until it suddenly is. But it is already history at that point when it is high. It doesn't project what will happen tomorrow or even by expiration date. Only what everybody else 'thinks' as implied by where they are trading reflected on the options market. Doesn't seem like collective behavior is in itself that much of an all seeing eye or an oracle to me. Essentially you're betting based on what others think is likely. That's like buying the market because an analyst on CNBC told you it's heading there by year end.

 

[yobo]

You're putting too much stock on efficient market hypothesis.

IV is not a predictor of future outcomes. It is ultimately at the core merely a reflection of market participant expectations in the options market.

Look at the VIX. Was at historic low levels weeks ago. Now it's way high. If you looked at what options told you weeks ago, it would have told you the sell off was 'improbable'. Yet here we are today.

I don't think it's a fool proof strategy to look at IV and then inferring some market move expectation and its likelihood. IV has a lag. It doesn't look like volatility will be high, until it suddenly is. But it is already history at that point when it is high. It doesn't project what will happen tomorrow or even by expiration date. Only what everybody else 'thinks' as implied by where they are trading reflected on the options market. Doesn't seem like collective behavior is in itself that much of an all seeing eye or an oracle to me. Essentially you're betting based on what others think is likely. That's like buying the market because an analyst on CNBC told you it's heading there by year end.

 

[yobo]

This thread is getting silly. I post a strategy that has been successful ytd for me and over many mrkt cycles and what do I get...

A bunch of nay sayers talking smack about gamma delta market efficiency steam rollers etc.

Nothing works 100% of the time, but if you find something that works for you, keep doing it till it doesn't.

Selling Otm puts against stocks that are in a neutral to bullish trend works. Plain and simple.

 

[beefcaketrade]

This thread is getting silly. I post a strategy that has been successful ytd for me and over many mrkt cycles and what do I get...

A bunch of nay sayers talking smack about gamma delta market efficiency steam rollers etc.

Nothing works 100% of the time, but if you find something that works for you, keep doing it till it doesn't.

Selling Otm puts against stocks that are in a neutral to bullish trend works. Plain and simple.

I don't think discussion and discourse is a bad thing. Neither is a healthy dose of self doubt and awareness to keep one in check. The whole thing about broadening horizons, etc etc.

I think we can all agree there is no right way to trade.

About the "keep doing it until it doesn't work" idea. There's often a problem with that. The 'convexity' and asymmetry problem. While doing something that has worked in the past can lead to steady gains, it takes just a paradigm shift in the market that one is not quick to respond to, to potentially lead to much more substantial losses that can wipe out all gains. Doing something that works is also survivorship bias at it's core as well. Market moves in particular are asymmetric. Markets have an upward bias. There is no doubt about it. But gains are generally gradual. But falls are much more dramatic and happen in much quicker succession.

Occasionally you hear about these hedge funds that make steady gains trading a strategy and chugging along, until bam, things change and the portfolio nose dives.

Regarding put selling, why not simply go long the underlying? In theory you can obtain more gains that way than OTM put selling that limits your upside while you continue to 'chase' the strike of which you sell puts in the future, which once it tanks at higher strikes can leave you holding the bag. There was another thread where a guy was bearish on the market and calling tops, but he sold calls which limited his profit. Instead, if he were so sure the market will tank, he could have simply shorted and obtained the full delta exposure of a market fall and thus bagging a lot more money.

I'm not bashing your OTM put selling strategy. I can't speak for others but I can appreciate the merits there as well as the potential pitfalls. I'm more interested in how you go about executing the put selling followed by call selling strategy. What is the methodology. What are the rules. Do you ever double down. Where do you cut losses. If price blows right pass your strike and you can't sell a call anymore worth of anything, what do you do. Things like that.

In your ideal world you'd be assigned a put after getting a hefty premium. Sell a hefty call. Get assigned away. Then sell a put again. Rinse repeat. That's all and good in a flat but noisy market. But if markets make decided strong moves, you start to chase, or you are bag holding. There are only two outcomes. In those cases, being straight up long or short may have been better trades.

 

[ironchef]

Seriously, if it were that easy everyone would be doing this. Yet they don't actually do that - they sell closer to the money and hedge deltas to remove delta from the equation and focus on vol.

May I ask, if I do that, how frequent do I have to hedge delta when it moves and how accurate do I have to maintain delta neutral? When it moves 1%? 5%?...

Appreciate your comments.

 

[yobo]

I don't think discussion and discourse is a bad thing. Neither is a healthy dose of self doubt and awareness to keep one in check. The whole thing about broadening horizons, etc etc.

I think we can all agree there is no right way to trade.

About the "keep doing it until it doesn't work" idea. There's often a problem with that. The 'convexity' and asymmetry problem. While doing something that has worked in the past can lead to steady gains, it takes just a paradigm shift in the market that one is not quick to respond to, to potentially lead to much more substantial losses that can wipe out all gains. Doing something that works is also survivorship bias at it's core as well. Market moves in particular are asymmetric. Markets have an upward bias. There is no doubt about it. But gains are generally gradual. But falls are much more dramatic and happen in much quicker succession.

Occasionally you hear about these hedge funds that make steady gains trading a strategy and chugging along, until bam, things change and the portfolio nose dives.

Regarding put selling, why not simply go long the underlying? In theory you can obtain more gains that way than OTM put selling that limits your upside while you continue to 'chase' the strike of which you sell puts in the future, which once it tanks at higher strikes can leave you holding the bag. There was another thread where a guy was bearish on the market and calling tops, but he sold calls which limited his profit. Instead, if he were so sure the market will tank, he could have simply shorted and obtained the full delta exposure of a market fall and thus bagging a lot more money.

I'm not bashing your OTM put selling strategy. I can't speak for others but I can appreciate the merits there as well as the potential pitfalls. I'm more interested in how you go about executing the put selling followed by call selling strategy. What is the methodology. What are the rules. Do you ever double down. Where do you cut losses. If price blows right pass your strike and you can't sell a call anymore worth of anything, what do you do. Things like that.

In your ideal world you'd be assigned a put after getting a hefty premium. Sell a hefty call. Get assigned away. Then sell a put again. Rinse repeat. That's all and good in a flat but noisy market. But if markets make decided strong moves, you start to chase, or you are bag holding. There are only two outcomes. In those cases, being straight up long or short may have been better trades.

In regards to "why not just go long?" Because someone is willing to pay me to go long at lower prices. Less risk. If the stock continues to go higher and my short put expires worthless, I'll probably just sell another put the following week and follow the trend. If there is a sudden spike upward, yeah sure I miss that profit, but who cares, I still made money.

In regards to what to do if a short put goes in the money, the answer is fairly simple. There are only so many choices and it depends on the math and whether the stock is still above the 52 SMA. But I will either assume the stock and sell CC's or I will roll down and out the put assuming I can sell at a higher price than what I bought it back for. If the price is below the 52 week sma, I will most likely take my chops and lick my wounds.

Also remember, I am diversifying amongst several positions. This helps to mitigate company and market risk as well as selling out of the money puts which in essence places a bid below market value at that point in time.