1. Know your fundamentals: Many self-proclaimed option gurus will dazzle you with gammas, betas and impressive looking formulas that remind you of your calculus final in high school. Most of these are simply different ways of looking at volatility.
True, volatility plays an important role in option trading; however, many options traders will buy or sell an option based solely on volatility studies. Ask the volatility player who sold $65 crude calls last summer as a volatility play what he thought of it when crude oil hit $79 per barrel. The importance of volatility is dwarfed by the core fundamentals that drive the underlying contract.
Bottom line: The market does not care what volatility studies show. A relatively expensive call option can become more expensive if the fundamentals make it so. It’s important to know the volatility. It’s more important to know your fundamentals.
2. Diversify: This basic rule of investing applies to option selling as well as any other strategy. It’s simply not worth the risk to roll the dice on one big trade. At any one time, there are option-selling opportunities in many markets. However, do not diversify simply to diversify. You should be looking for the best trade opportunities on the board. A good rule of thumb is to maintain trades in three to five markets at any given time. Less than this can concentrate risk. More than this can dilute returns.
3. Sell out-of-the-money — far out-of-the-money: This is the key to successful option selling. Many new option sellers make the mistake of selling close-to-the-money options in hopes of turning a quick profit. Many strategists teach that options experience their fastest time decay during their last 30 days before expiration. This is true, but to capture any real premium in options, even futures options, with this little time remaining requires selling strikes dangerously close-to-the-money.
