Why to Sell Options

A helpful analysis on why to sell options. Contains helpful tips, strategies and examples of why selling out-of-the-money options makes sense and sets the odds in your favor.

why to sell options

Why to Sell Options and How It Improves Your Odds

January 5, 2023 | by OptionDirection Team
Introduction

As a trader, you are well-aware that trading is a risky endeavor. This is true for stock trading as well as for options trading. A specific way of options trading, however, enables a trader to set the odds in their favor. This “way” that I’m referring to is selling out-of-the-money (OTM) options. In this article, I’ll go over why to sell options and how it can greatly improve your odds of success.

By selling an out-of-the-money option that is far away from the current stock price, your odds of exiting the position at a profit are much more favorable than 50%, as compared to just buying/shorting the stock or buying/selling an at-the-money option (both of which have around 50-50 odds).

In this article, I will also explain why this strategy makes more sense in times when volatility is elevated.

Why it Makes Sense to Sell OTM Options

Let’s say SPY is currently trading at 360, and you were bullish on the stock. (In case you’re bearish, you could sell calls instead of puts.) If you were to buy the stock outright, then you have about a 50% chance of profiting. However, if you instead sold the 330 put option expiring in 51 days, not only are you paid a $540 credit for entering the position (in the form of options premium), but you have also enhanced your odds to an 84% probability of profit (POP).

If you’re expecting SPY to trade above 330 by the option’s expiration date, this trade makes a lot of sense. Not only does it give you the chance to buy the stock for much cheaper (330 vs 360), but it also gives you more leeway to be wrong in the coming weeks while you have the position on. Let’s say you wanted to increase your probability of profit even more. Well, in that case you could sell the 325 put instead of the 330 put. Your probability of profit goes from 84% to 88%, although you would receive less credit since you chose a farther away strike. Since your risk of being in-the-money at expiration is lower (for 325 strike vs 330 strike), you are being paid a lower credit to compensate you for your risk.

Now let’s consider a scenario where the stock drops from 360 to 345 in the next week or so. If you had bought 100 shares of SPY outright when it was at 360, then you’re sitting on a loss of $1,500. In comparison to buying the stock, if you had instead sold the 330 put, not only would your loss be much lower, but your put option would still be out-of-the-money (because SPY is still above 330), meaning that the odds are still in your favor that this position will be profitable.

What’s the Goal When You Sell OTM Options?

The goal when you sell an out-of-the-money option is to make time decay work in your favor, making you money as the days go by. At the time of the put option’s expiration, if SPY is above 330, then the 330 put that you sold will become worthless. That would mean that an option that you had sold for $540 is now worth $0, so you can theoretically buy it back for $0. You just netted $540 on this hypothetical trade!

When to Exit a Position

Unless you’re looking to own the stock, we generally don’t advise holding an option until expiration since we have found that the risk-reward ratio is optimal when you close out the position once you have already made around 50% of the max credit collected. In other words, you may choose to buy back the put and exit the position when you made around $540/2, i.e. $270 in profit.

In the case of a losing position, we generally advise to exit when your loss exceeds 1.5 to 2 times the credit collected. In other words, you may choose to exit when the loss on the put reaches $540×2, i.e. $1,080. An exception would be if you are an investor who is willing and able to take assignment of the stock at the 330 price. In that case, if the stock closes at or below 330, you would be assigned the stock at 330. And since you didn’t exit the put, you still have the $540 credit that you collected when you opened the position. This credit has lowered your cost-basis on the stock by $5.4 per share (i.e. $540/100). It would be as if you bought the stock for 324.60!

Please note however, that the general guidelines that I have provided above may be altered in different scenarios or for other types of options strategies.

Reducing Assignment Risk When Expiration Nears

If an option that you sold now has around 21 days or less until expiration, you may choose to “roll” the option out into the next expiration month, as explained below. For instance, let’s say that your November SPY 330 put now has only 21 days remaining until expiration and you want to reduce your risk of being assigned the stock at expiration. Regardless of whether the option is currently in-the-money (i.e. SPY below 330) or out-of-the-money (i.e. SPY above 330), “rolling” would involve buying it back to close it, but at the same time selling a new SPY 330 put option for December expiration.

This roll should be done for a net credit. In other words, you should get paid to do this roll. To improve your odds of profitability, you could even select a lower strike for the new option (e.g. 325) if it results in a net credit for the roll. Let’s say you collected $200 for this roll. Now your total credit received is $540+$200, i.e. $740.

And technically, if needed you could keep rolling into the future to collect more and more credit. This way, eventually when the stock changes course and moves in your favor (as stocks oftentimes do), you will make a profit (or reduce your loss) since you have collected a high credit for your roll(s). Being able to roll for an additional credit is a another reason why it makes sense to sell options.

Are You Bullish, Bearish or Neutral?

The example that I provided above was for selling a cash-secured put, which is just one way, among many others, to take a bullish position on a stock using short premium strategies (i.e. strategies where we sell options to collect premium).

Here are some basic bullish short premium strategies:

Here are some basic bearish short premium strategies:

Here are some basic neutral short premium strategies:

What Role Does Volatility Play?

A big role! Options lose value when the stock’s volatility contracts, so a drop in volatility would benefit your out-of-the-money short put. That is why we recommend opening “short-premium” options positions only when volatility is high, so that when volatility reverts back down, our options become cheaper, and therefore profitable. “Short-premium” positions should generally not be opened in times of low volatility, since a spike in volatility would not be beneficial.

When volatility is low and you’re expecting it to rise, it may be better to open “long-premium” options positions that benefit from an increase in volatility. You may not receive a credit to open these positions (i.e. you may have to pay a debit) but they can also be set up in a way that the position benefits from the passage of time. Some examples of such positions include debit spreads, calendar spreads and diagonal spreads.

One assumption, based on historical data, is that volatility is mean-reverting, which means that when it gets too low it will eventually get higher, and when it gets too high it will eventually get lower.

Here is a table that summarizes how time decay and volatility affect short vs long-premium positions:

Type of Position

Credit or Debit

Effect of Time Decay

Effect of Volatility

Short-Premium Position

You receive a credit for opening position

Benefits from time decay

Benefits from volatility contraction

Long- Premium Position

You pay a debit for opening position

Can be set up to benefit from time decay

Benefits from volatility expansion

Conclusion

In summary, here are the reasons to sell options in times of elevated volatility:

  • You get to collect options premium by betting that a far away strike will not be breached at expiration. The odds are set in your favor.
  • You can choose your probability of profit (POP) by choosing how far out-of-the-money to choose your strike (e.g. 325 strike put has a higher POP than 330 strike put) although choosing farther away strikes will result in less premium collected.
  • Time decay of the option is working in your favor. At the time of expiration, the option will become worthless if it remains out-of-the-money. Therefore, as more and more time passes and the option remains out-of-the-money, it will gradually reduce in value resulting in your position becoming more profitable over time.
  • If you sold the option when volatility was high, assuming that volatility is mean-reverting, the position will eventually lose value when volatility reverts lower. This would make your position more profitable.
  • If your directional assumption turns out to be wrong and the stock moves against your position with option expiration nearing, then you could roll the option into a future expiration month to reduce your stock assignment risk. The bright side is that you can collect more credit every time you roll, in the hope that you will eventually become profitable or will be able to reduce your loss by doing so.
  • In case you are a stock investor looking to buy a stock at a lower price, selling an out-of-the-money put makes even more sense since you are receiving a credit to do so, which lowers your cost-basis even further if you are assigned the stock.

Even though we covered the advantages of selling OTM options in this article, it should be noted that many situations call for buying options as well, especially when volatility is low. Click here to read our article on how to choose whether to buy or sell options. 

To learn how to get started as an options trader, click here for a step-by-step guide. 

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