There is a lesson to be learned from that classic, American poem – and it applies to us, as option traders. Most successful option traders learn to adopt a premium-selling strategy, rather than becoming premium buyers.
Although this is not the place for a lengthy discussion on why this is true, traders soon learn that people who buy options only succeed when they can consistently guess in which direction the stock market (or their specific underlying asset) will move during the lifetime of the option. And even that is not enough. Traders must choose an appropriate strike price and expiration date – all the while being certain that they do not overpay for their options.
On the other hand, out-of-the-money premium sellers not only earn a profit whenever the price of the underlying asset behaves (i.e., does not move in the wrong direction), but they also collect when the asset price remains in a narrow range. To make premium selling even more attractive, sellers can earn a profit even when the underlying asset’s price moves in the wrong direction – as long as that price movement is not too large (i.e., the underlying’s price does not approach the strike price of the option sold).
Obviously there is no guarantee of making a successful trade when selling calls and/or puts or when selling call and/or put spreads (selling a spread means collecting a cash credit for a spread in which both options expire at the same time).
There is one other potential problem for premium sellers, and that is a sudden rise in the implied volatility of the options sold. Fortunately for those who prefer to sell premium, these situations are not common – but they are not especially rare either. Big, market-moving events, such as an unexpected result at the polls (Brexit, for example), a political assassination, or a terrorist attack (9/11/2001, for example) are rare.
Much more common are quarterly earnings reports from individual companies or FDA announcements concerning important clinical trials for new drugs.
The premium seller must be able to survive these market events and the best way to do that is to be careful and to be informed. By managing position size (i.e., the number of options or spreads that one trades) the trader can be certain that a worst-case scenario does not severely damage his/her trading account. By being aware of when important earnings news (i.e., AAPL, or IBM in bygone days), is expected, and especially by being aware of when news is expected for stocks in your portfolio, you will (hopefully) never be caught owning positions that are too risky for your account size and comfort zone.
Once a trader becomes a premium seller, it is (psychologically) difficult for that person to consider premium-buying strategies. There is something comforting about collecting time decay (i.e., positive Theta) – rather than paying it -- that makes it a difficult strategy to abandon. However, that leads to a huge problem for careless traders. A string of winning trades can blind the trader to the risk that comes with premium selling. If you are careful to adopt an appropriate position size with every trade, and avoid the trap of feeling invincible, you can do well when selling premium.
The overall attractiveness of premium-selling must not prevent traders from researching strategies that allow for going against the grain – i.e., by seeking the path not taken by the majority of traders.
Based on the discussion above, you may (correctly) conclude that the random purchase of options and option spreads is statistically likely to result in a monetary loss. However, by adopting these strategies at an appropriate time (based on historical research and back-testing of different strategies), it is possible to buy option premium -- using a disciplined approach – and come out ahead. For an example, the folks at SteadyOptions have been able to adopt a straddle buying strategy with great success.
Can you do the same at home? Yes, if you have the time and computer power to collect and analyze a ton of data. For most individual investors, this is a much-too-difficult endeavor.
So, what are the basic ideas for being able to generate profits when paying (rather than collecting) the premium? A very significant part of that approach involves understanding the true meaning of the word ‘discipline.’
Whenever a new trade is initiated, there should be a plan – written where it can be easily reviewed. If you are buying premium for a specific reason – such as knowing that earnings news will be released in the very near future, then remain focused on that reason. If the stock rallies (or falls) prior to the announcement, and especially if implied volatility has increased, take your profits before news is released. Do not hold onto the (currently) profitable trade when the position is far from market neutral. Remember the plan. You did not make the trade to be bullish or bearish. You made the trade to earn a profit from either a significant market move or a good-sized increase in IV. Take your gains and, if you can do so at a reasonable cost, create a new position for the news event. This adjustment trade should take cash off the table because there is no reason to place the earned profit at risk, unless the cost is attractive.
Good discipline involves knowing when it is time to abandon a trade and lock in profits or losses. Don’t scoff at this idea. Many a novice trader (and also those who should know better) has held onto a winning trade, only to see a nice profit become a sizable loss. And far too many traders refuse to accept any loss and hold onto a position, only to find themselves with a far larger loss later.
There is nothing wrong with trying to milk additional profits from a winning position, but the disciplined trader knows how to adjust that position to both lock in a substantial portion of the gains and still own a limited-risk position with the opportunity to increase profits.
The disciplined trader also knows that when things go awry – such as when the news is announced and the market gives a big yawn – just exit the trade, accept the loss and move on. Do not hold, hoping for a miraculous stock price change.
Premium buying is the less-traveled road, but it can be profitable for the well-prepared, disciplined trader. It doesn't mean it is better or worse than premium selling. It just means that there is more than one road to Rome.
Don’t be a bystander or a passive spectator to your own life, choose wisely and create your own reality.
Mark Wolfinger has been in the options business since 1977, when he began his career as a floor trader at the Chicago Board Options Exchange (CBOE). Since leaving the Exchange, Mark has been giving trading seminars as well as providing individual mentoring via telephone, email and his premium Options For Rookies blog. Mark has published four books about options. His Options For Rookies book is a classic primer and a must read for every options trader. Mark holds a BS from Brooklyn College and a PhD in chemistry from Northwestern University.