Supercharge Your Trades Selling Options

Some people believe options should be traded, and some believe they should not. Option traders are convinced options provide the best opportunity to make a large profit quickly, and for the most part, those who stay away from trading options tend to think of options as too risky. Even in the realm of options traders, there tend to be those who like to buy options and those who like to sell options.

Those who like to buy options typically do an excellent job understanding the leverage and high ROI opportunities that options provide. But they tend to struggle with understanding why someone would take on the risk of selling options for what they consider a comparably low ROI. Similarly, those who favor option selling tend to appreciate the consistent, albeit lower, rate of return option selling brings. And they struggle to understand why option buyers would buy an investment that, by its very nature, is losing money as soon as the trade is initiated.

Why We Sell Options for Income

Option sellers have a different philosophy about trading than most. They are a lot like an insurance company. For example, think of State Farm, Allstate, or any of the big insurance companies that are familiar to you. All of these companies sell insurance policies and collect the premiums in exchange for taking on the risk. When you sell a stock option, you are essentially doing the same thing. You are taking on the risk of the trade, and in exchange for doing so, you are collecting the premium.

​The primary reason option sellers choose to sell is because they see it as a way to put the odds on their side. Option sellers understand the nature of stock options and the nature of the marketplace:

  • Stock options are continually losing money through time decay
  • The market is a game of odds where only 33% of the time, the trade goes in your direction

An option seller wants to take these two components and skew those factors in their favor.

Need the Price to go Down.

An option seller wants to take these two components and skew those factors in their favor.

When you sell options, you are taking a short position, and just like shorting a stock, you want the price of the company you have shorted to go down in value. Thus, as a short trader, if you can put the odds on your side to see the price go down, you will consistently win. When trading options, there are two ways the option price will go down in value:

  • Time decay
  • Stock direction

​Time Decay

Time decay impacts an option price by eroding the option's value every day as it is getting closer to expiration. The principle is simple, the more time you have until expiration, the more valuable the option is. The flipside is true; the less time you have until expiration, the less valuable the option is.

Time decay is a known factor of option pricing. We know it exists and is unavoidable. As an option buyer, we are trying to choose trades that will outrun the time decay. But as an option seller, we want to work with the time decay to make a profit.

Here's an Options Time Decay Graph:

As you can see from the graph above, from the beginning of the trade, the option is losing money. However, it starts to lose money at the end of the life of the option. It loses money 4-6x faster during the last two weeks of its life than during the first six months.

As option sellers, we seek to capitalize on that option price move. We sell the option and let the time value erode out of the option. Like shorting a stock, we short at one price and either cover at a lower price, or in the case of the option; we let it expire worthless.

​Stock Direction

When trading options, we have an absolute certainty that time decay will exist. However, we also must consider that stock prices move as well, which will also impact the option's price. Option calls go up when the stock goes up and down when the stock goes down. Option puts go down when the stock goes up and up when the stock goes down.

These probabilities are easy to understand as stocks can only move in 3 directions:

  • Up
  • Down
  • Sideways

As an options trader, we know when we buy a call option, there is a 33.3% chance of ​the option going ​up, and there is a 66.6% chance ​the option will stay the same price or go down. Option sellers seek to capitalize on this probability. 66.6% of the time, the option will stay the same price or go down, and 100% of the time, time decay is at work. With those odds set, the option seller has found the part of options trading that is more predictable.

​In Closing

Selling options is a more predictable trade to place than buying options. If you are willing to take the risk of option selling, then the rewards can be very favorable because of the consistency with which you can create profits based on the principle of time decay.