What is Selling Options Premium?

Selling Options Premium is a general term that refers to Options Selling strategies (as opposite to Options Buying strategies). Some examples of Options Selling strategies include:

Some examples of Options Buying strategies include:

Please note that getting a credit or paying a debit is not what defines a strategy. A butterfly spread can be done with credit (Iron Butterfly) or debit (regular Butterfly). What is typical for Options Selling strategies is the fact that they are usually theta positive, gamma negative, vega negative. 

Myths vs. Reality

Myth

80% of the options expire worthless, so selling them gives you an edge.
 

Reality 

According to CBOE, approximately 30%-35% of options expire worthless. But more importantly, percentage of options expiring worthless is irrelevant as we demonstrated in our article Do 80% Of Options Expire Worthless? This is an argument used by many amateur traders, and also by some options trading “gurus” to attract new subscribers. 
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Myth

Options Selling has high probability of success (80-90% winning ratio).
 

Reality 

First, not all options selling strategies have high probability of success and high winning ratio. For example, butterfly spreads have much lower probability (but better risk/reward). When referring to 80%+ winning ratio, it usually implies selling low delta credit spreads or iron condors. But what is important is not that you win 80% of the time, but what happens when you lose? If you make 5% on winning trades but lose 60% on losing trades, you are still losing money, right?

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Myth

Options selling has a lousy risk/reward. It’s like picking up pennies in front of a steamroller.


Reality 

This myth is an opposite of the previous one, used by options selling opponents. And again, risk/reward has inverse correlation to probability of success. Good risk/reward = low probability of success, and vice versa. 

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Myth

Options selling allows you to have extra income (they are sometimes called “income producing strategies”).


Reality 

A BIG FALSE. The fact that you are getting cash upfront doesn’t mean that cash will necessarily stay in your account. If the position goes against you, you will need to pay more to close it. If you want stable and reliable income, buy T-bills, dividend paying stocks etc. Options are NOT for income.

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Myth

If I sell options with 10 deltas, I have 90% probability of success.


Reality

This claim completely ignores Implied Volatility changes. This is especially true when selling puts. If the underlying starts to tank, IV will start to increase and the delta will start to increase at much higher pace, amplifying the losses.
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Myth

Selling weekly options will produce the best results due to higher positive theta.


Reality 

Higher positive theta comes with higher negative gamma. Those strategies are much more sensitive to underlying move, and the losses are much harder to control.
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Myth 

When selling premium, we can win in three scenarios: if the stock price stays the same, moves against us slightly or moves in our favor.


Reality

While this is true, it ignores the size of the winners in those three scenarios vs. the size of the losers if the stock moves sharply against you.
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Myth

One of the most important aspects of selling premium is the positive theta.


Reality

Yes, but those positions usually also have negative gamma and negative vega. In case of a big move (especially down move) the negative gamma and negative vega will play much bigger role than positive theta. It is very misleading to look at one Greek and ignore the others.

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Myth: A good way to capitalize on volatility crushing after earnings is to sell premium.

Reality: It is true that Implied Volatility increases before earnings and crashes after earnings. However, if the stock moves more than “expected” after earnings, selling premium will be a losing strategy because the gamma losses will outpace the vega gains. How NOT To Trade NFLX Earnings explains the concept.

Does Selling Options Premium Work Or Not?

The short answer is: it works most of the time – till it doesn’t. And when it stops working, the losses can be devastating. Just ask Victor Niederhoffer, Karen Supertrader, James Cordier and many others.


The main reason Selling Options works in the long term has nothing to do with 80% of options expire worthless, 90% winning ratio or other myths. The main reason it works is that Implied Volatility (IV) tend to be higher on average than Historical Volatility (HV), especially on indexes. When using a strategy, please make sure you understand why it works or doesn’t work in the long term.

Selling options has its advantages and disadvantages, so is buying options. It’s not about the strategy, it’s how you use it. Risk management and positions sizing are the key.
 

If you do insist to sell options, here are few simple rules that might help you to reduce the risk:

  • Always look at risk/reward. Don’t be attracted to high probability low delta options. Those trades might work well for many months (or even years), but inevitable will eventually happen. They are a true definition of “picking up pennies in front of a steamroller”.
     
  • Never underestimate the risks of leverage, especially when you sell naked options.
     
  • Be very careful with selling weekly options due to high negative gamma.
     
  • Be aware that earnings are a binary event if you decide to sell options before earnings and hold them through the event.
     
  • Never sell naked options on individual stocks. The risk of unexpected event like acquisition, earnings warning, analyst upgrade/downgrade is too high.

Conclusion

Selling Options Premium can work, and it should be part of well diversified options portfolio. However, in my opinion, you should always have other strategies to balance your portfolio and control risk. Having only options selling trades in your options portfolio is a certain path to ruin.

 

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