This is a newbie friendly introduction to how selling options for income works. We’ll cover the process of doing it, risks and opportunities of it and theory behind doing it.
Previous part https://read.cash/@passiveincome/an-introduction-to-passive-income-by-selling-options-a341a53f
Selling Premium
Options traders usually refer to selling options as “Selling premium”. What “Premium” is and the different things that affect it will become clearer as you read through this but for now you can just think of “Premium” as markup. A profit margin. Premiums are where option sellers can make money, but these come at the cost of risk.
The reason an options seller can get the premium is they are taking on the risk. The person buying the option is either hedging or speculating on the outcome of something and you’re taking on the liability of paying them off on their bet if it comes in a winner. Huge profits can be made with winning options, so there can be a lot of risk in this.
How Risky is Selling Options?
Selling options without using the correct strategies to protect yourself can have limitless risk. Really! Limitless. The amount that could be lost on an option that won in a very rare event (Or even just a very surprising one) can easily be enough to bankrupt a person. Luckily the strategies to protect against this are easy. Allowing control over your risk.
More about these strategies to protect from risks will be explained as we go on. For now it’s just important to know that you can clearly and carefully define your maximum risk in any options deal but if you do not use these methods of protection your losses can sometimes be theoretically endless.
Why Take Any Risk?
You may be wondering at this point why this is even worth it. If losses can be endless and even using methods of protection you can still lose why is this even worth it? Isn’t it just gambling? The answer is although you do take on risk, you’re on the side that has all the advantages. “Premium” prices are paid to you and 80% of options do not win.
To understand how the options seller is on the favorable end of the deal it’s best to think of it as being similar to when an insurance company charges a premium to insure you. The insurance company is taking on potentially a lot of risk if something happens, but they know most of the time nothing happens and they charge more for each risk they perceive.
The options market is set up similar to this with the sellers setting the price based upon the risk of it happening. The risk of it happening is always set a little bit above the real risk of it happening (Based upon historic averages and known future events), meaning the option is being sold at a premium.
One of the most important factors in the pricing of a stock option is how much the stock usually moves. This is known as “Volatility”. How much the stock really moves is real volatility. The more important factor is how much the options buyers seem to think the stock will move. This is known as “Implied volatility” (IV) and prices will be set based on IV.
Here’s where this all either starts to make sense and if not, this is probably not for you (And it’s not for everyone). At almost all times the implied volatility is higher than the real volatility turns out to be. Only in extreme cases is the real volatility higher than the implied volatility was. This is important, because the implied volatility is what is paid for and it almost never happens.
Above is a chart to illustrate this point. The blue line is the implied volatility and the green line is real volatility. At almost all points in time the blue line holds steadily above the green and only on very rare occasions do they touch each other. The blue line is what your risk is being priced at and the green line is what the real risk was. Selling premium has a high probability of winning.
It’s important to re-introduce at this point the words, “Endless risk”. People get into trouble with selling options because such a high percentage win that they can become complacent or ignorant of the risk. In the few times the green and blue touch/cross explosive losses would have been made if you’d not used ways to protect yourself.
So the bottom line here is when we use the correct strategies to sell options we can create opportunities where we are going to make money most of the time and also have ways to ensure we are limiting the maximum amount of money we can lose. We’re basically betting against anomalies in the markets. Which really do not happen that often.
How Do I Protect Myself?
To understand this first you need to understand how you can end up on the hook for endless risk in the first place. What’s actually happening when an “Option wins”. Let’s say you sell a call option on Stock X for $110 when the stock is $100. Something extraordinary happens with the company and the stock price shoots to $1,000. What happens to you?
Well, it sucks! The option you have sold has agreed that you will sell the option buyer 100 shares (Per option) of this stock for $110. That means you have to go and get 100 shares of this stock to give them … but these are now trading at $1,000 a share. So you’re needing to fork out $100,000 to get the stock, to sell to him for $1,100. Not good. Isn’t worth the premium.
What we’d do here to protect ourselves is very simple but really quite clever and it’s known as a “Call spread”. When we sell the option for $110 we also buy an option for a higher price, for example $120. Now we have a much more secure position. We’re still obligated to give someone 100 shares of stock X at $110 no matter how high the price goes, but we also have someone else who is obligated to sell us 100 shares for $120.
When we do this we can clearly define what our risk is going to be. It means we make less premium because we have to buy an option (Meaning we’re paying someone else premium) but we are not exposed to endless risk. We know how much we can lose before we put the trade on.
There’s always going to be a window of profit to be made when we sell an option for $110 and buy an option for $120 because the chances of $110 hitting are always going to be higher than $120 and this means the premiums on this are always going to be higher. How wide you do this determines how much premium you make and what you can lose.
Let’s look at an example of how widening the spread affects the amount that can be made and lost. Instead of buying the call for $120 we bought a call for $210. While the stock is trading at $100 the chances of it hitting $110 are incredibly higher than the chances of it hitting $210. The premium on one would be much, much higher than the other.
But the difference is you now have a lot more at risk. If the stock goes to $1,000 before you could have bought 100 shares at $120 and now you have to buy them at $210. Before if the stock went to $130 you’d still just pay $120 but now you have to pay $130 (And whatever it is all the way up to $210). Much more is risked.
How Much Can I Make Selling Options?
To answer this first we have to establish what you can risk. When selling options that have a high probability of winning you’re usually going to be risking about 3 times as much as you can make. So if you can risk $100 per trade you can make around $30 per winning trade. Doing this your probabilities of winning are around 70 - 75%. Which gives winning odds.
When successfully deploying a winning options trading strategy your profit/loss curve is going to look like this.
Steady small wins broken up by big drops when unusual things happen. The main factor to success in selling options is being able to do enough of them so that the winning odds you have are able to play out in your favour. The more bets you are able to make the more likely you are to make money over time.
This is important to consider when choosing how much you risk. If you have $10,000 in total to risk and risk $10,000 in a trade an unlucky event can see you broke. If you risk $1,000 per trade it’s a lot less likely and if you risk $100 per trade you have a strong probability of long term success.
How Long Does it Take to Make Money?
This depends upon the type of option you sell. It’s possible to sell options over just a week and even over just a day but these can be a lot more risky. Better odds are created when selling options that have about 45 days on them and then closing out after about 20 days have passed. So it would be about 3 weeks before the option was settled and premium secured.
This is something you can do recurrently through the year. Selling options in a cycle and closing them out about every 20 days. This produces a somewhat regular income but of course you have to account for the fact that sooner or later there are going to be losses to pay out and you need to maintain a bankroll to cover that.
Conclusion
Selling options can provide you with a situation in which you have a clear statistical chance of making money in most of the deals you do, but this does come at the cost of having the potential of limitless risk if you do not protect against it and your average loss will be bigger than your average win when you do use risk protection measures.
It is something that is a very doable thing. Selling options does not have to involve a lot of complex analysis, understanding of financial markets, a strong grasp of the fundamentals of the stocks you’re dealing with or any degree of high financial literacy. All you have to do is learn how to sell options when the premiums are really high and to manage the risk properly.
With that being said, options trading is not something one should take lightly. There is a significant amount of risk if you get things wrong or if your emotions get the better of you and you begin to approach the market with more of a gambler's mentality than a business like mentality.
Strategies for selling options that give you high probability and limit the maximum loss you can have are freely available to learn, simple enough to execute and they do work but require the patience to learn and the discipline to implement consistently. There will be times there are losses and you have to handle them well to get through them.
For a serious delve into selling options a person has to learn the strategies to use, the odds these strategies produce and then implement these using a suitable size of risk over a large sample size of trades. Both the technical and emotional sides of this are critical to long term success selling options.
If you found this post useful, you can find more of my posts on Reddit at Earn passive income through various online sources. (reddit.com)
