Selling Stock Options

The Smart Profits Report: Issue #337
Monday, July 31, 2006

Selling Stock Options: Know This Key Selling Method To Profit With Options
By Lee Lowell
Advisory Panelist, Mt. Vernon Research

Any conversation about taking profits, is sure to prick up everyone’s ears. But did you know that there’s a difference in profit-taking methods when holding options positions? It’s a difference that can mean big dollars in your pocket.

It arises when you hold a “short” option position versus a long option position. When I say a “short” position, I don’t necessarily mean you’re bearish - I’m actually referring to selling stock options, as opposed to buying them.

Here’s how it works…

How to Boost Your Profit Probability Through Selling Stock Options, Not Buying

If you’ve ever sold stock options - whether it’s part of a spread trade, or a much riskier “naked” position - you’ll know that the most you stand to gain is the amount of premium you take in from the buyer. That’s it. You can’t make any more than that. On the other hand, when you buy a stock option, your reward can be unlimited.

But here’s the kicker: In my options trading experience (including six years in the NYMEX pit in New York), when done correctly, selling stock options has a much higher probability of gain. Here’s the key differences:

Selling Stock Options: When you sell an option, someone pays you the cash for it first. The object of the game then is to hold onto that money and have the options expire worthless, so you don’t have to give back any of the money you collected upfront. In short, when you sell a stock option, specifically an out-of-the-money (OTM) option, you really don’t need the direction of the stock or commodity to come into play as much as you would when buying options.

Buying Stock Options: But when you buy an option, you need two things to happen for you to make money. First, you need it to move in the direction you want in the time allotted. Second, you also need it to move a good distance. And sometimes, the chances of that happening are pretty slim.

So when you’re the seller of those OTM stock options, you just need to sit back and wait for the options to expire worthless. The difference is that even though selling a call option or selling a put option has a somewhat directional bias, its profitability doesn’t solely rely on getting the direction right. With a short stock option position, you can still emerge a winner, even if the underlying security moves up, down or sideways. As long as the security doesn’t go blasting past your short option strike price, you’ll win if it expires worthless. Once the option expires, you get to keep the money you collected upfront, free and clear.

The Buyers Battle… The Clock Ticks… And Your Profit Chances Increase

You could say that short stock option sellers are the ultimate “hands-off” traders. They’re simply wishing time away. This is because the sooner expiration comes, the sooner they get to keep the option premium. If you’ve done all your analysis and feel comfortable about the OTM options you’ve sold, then you just need to sit back and watch the option decay until expiration.

Meanwhile, the option buyers are fighting an uphill battle, not only against the stock or commodity’s direction, but against time as well. They need to micromanage the trade, constantly watching to see if the security is moving in the right direction. At the same time, each day that passes means time decay is eating away at the options and they’re losing value.

For a seller, this is a great scenario. Every day an option loses value, the closer it is to zero, and the closer the option seller is to having a winning trade.

Another Handy Benefit To Selling Stock Options

When you’re selling stock options, if your position expires worthless, you don’t need to shell out an extra commission fee to close the trade. Once an option expires, it’s done. You don’t need to be closed out.

This is killer for many options buyers. Some simply let their long options die a slow death until they eventually expire worthless. Sure, they didn’t have to spend the extra commission costs to close it out - but they still lost 100% of their option investment.

But sellers have the luxury of not spending any money to close out the trade - and keeping 100% of their profits.

Most options buyers also tend to take action on their long positions at some point during their lifespan. This entails splashing out extra commissions. But as a seller, you can save yourself a significant amount over the course of a year simply by letting your short stock options expire.

So does that mean you just sit just sit around, waiting for expiration? Nope…

Get Up and Cash Out: Two Reasons to Play the Short Side for Hassle-Free Gains

Not all short stock options positions will expire worthless. In my own experience, I’ve encountered many occasions where I’ve closed out profitable short options trades before they’ve expired. One rule that I like to follow is that if my short stock option position has returned about 70%-80% of its potential profit, I will close the trade ahead of time. This allows me to bank a profit before the market has a chance to reverse on me and dent those gains.

So if the time-decay bug has bitten you in your options trading experience, selling stock options is one way to fight back. With time decay working every day until expiration, it doesn’t take too long before you could be sitting on some tidy gains from your short position.

In addition, if you’re the kind of investor who doesn’t have the time to sit at a computer and watch the market all day, this strategy can work very well for you. While options buyers need to keep an eye on their positions more closely and frequently decide what to do next, it can be a stressful and emotional experience. And when emotions muddy the water, that’s when judgment gets clouded and decisions become harder.

Your position is simple, though. As an options seller, you can relax a little more, safe in the knowledge that time decay is taking care of your profits for you. That makes the profit-making decisions much easier.

Good Trading,

Lee Lowell

Today’s Smart Profits Cribsheet

It’s a lucrative strategy… but one that’s surprisingly underused by many investors. Don’t be one of them. Find out how you can harness the power of selling options and pad your portfolio in this comprehensive Smart Profits #270, Selling Covered Calls: Getting Cash for Stocks You Already Own.

Do you know when to hold ‘em and when to fold ‘em? Get some helpful tips in Smart Profits #295, Option Profit-Taking: Making It Easy To Take the Money and Run.