As a group, option sellers tend to be efficiency oriented. Always attuned to maximizing odds, sellers key toward being efficient, and efficiency often can mean getting the most bang for your buck.
To option sellers, that means collecting big premiums.
There are many ways to bring in higher premiums for the options you sell. Leaning toward a more risk-averse stance, not all of these methods are advocated all the time. However, taken as a whole, these techniques will provide a solid primer and a broad arsenal for generating the maximum amount of premium for your account when you write options.
1. Sell naked
Spread positions have merit, but for pure premium collection, there is no way to get bigger premiums — and realize those premiums more quickly — than selling naked positions.
While the word conjures up images of being exposed to too much risk and thus discourages many investors from exploring it, naked option selling can be done responsibly and effectively. It’s the cornerstone of the option-selling philosophy.
While naked risk must be managed more closely than covered risk, you are doing yourself and your portfolio a disservice if you do not consider selling naked in at least some situations. It’s the power play, the strong side sweep and the right hook in an option seller’s arsenal.
2. Sell strangles
Selling strangles is a popular option strategy. While not ideal for hard trending markets or breakout moves, selling strangles (selling a put and a call in the same market) can be an amazingly versatile strategy. It can be deployed in a wide variety of market conditions and has a magical effect on boosting your premium: Doubling your premium collected while reducing your margin requirement (as a percentage of that premium).
For instance, selling the put may bring in $500 premium and carry a $1,000 margin requirement. Selling the call may do the same. But selling them at the same time brings in the same premium but lowers the margin requirement. Thus, selling the put and call together brings a greater return on invested capital.
As a bonus, selling a strangle also comes with some built-in risk temperance. A move against your call is at least partially offset by gains in your put (and vice versa). Thus, a strangle can be a flexible way to build account premium quickly.
3. Sell closer to the money
While not the first choice for collecting higher premium, selling options with strike prices closer to the current market will increase the premiums you collect (see "The money’s in the money").
For the risk-averse trader, this may be troubling because the closer you sell to the money, the better chance for your options to go in the money — a place no option seller wants to be. But, moving a strike or two closer sometimes can make a big difference in the premium you collect, especially in markets where deep out-of-the-money strikes are available and fundamentals support your position.
For instance, if coffee is at $1.50 per pound, it probably isn’t going to make a big difference from a risk standpoint if you sell a $2.90, $2.80 or $2.70 call. But it could make a noticeable difference in the premium you collect. In this type of situation (all strikes are deep out of the money), selling the closer strike can make sense.
4. Sell more time
This is a more conservative method of collecting higher premiums than selling closer to the money: Sell options that are further from their expiration date. The more time left on your option, the higher the premium you can collect.
The tradeoff is that you have to wait longer for the option to expire. Many traders do not have the patience for this. Others feel that selling more time allows a greater window for something to happen in the markets that moves against your position. If you want to reduce the chances of something happening in this sense, know your fundamentals and seasonals. Sharp moves can happen in any market. However, they are less likely to occur in markets where fundamentals do not support them and often are limited to specific seasonal periods.
Selling more time can be a slow path to higher returns.
5. Sell volatility: Fade the news
It’s no secret to most option sellers that higher volatility means higher premiums. Volatile markets bring in more speculators who not only drive prices in the underlying, they buy options. This means demand — and, thus, premium — for the options goes up. Typically, as an option seller, this will mean more opportunities for you.
This is not to suggest you should sell in front of runaway, breakout moves. However, a spike in volatility often creates ridiculous strike prices temporarily available to option sellers. Investors tend to get carried away or lose their heads in the excitement of fast-moving markets. As an option seller, you can use these situations to your great advantage.
Shortly following a spike in volatility often can be a great time to sell options. A good example is after a surprise government report. An unexpected report comes out, and prices of the commodity in question must adjust to reflect the new numbers. This often (though not always) plays out quickly — over a period of one to three trading sessions. After that, the market has priced the new number and trading resumes as normal. This also can work when a significant announcement has been well publicized (see "Fade the news").
It even is common for the option to price in the most extreme possibility in the first day and then adjust its value lower as the price of the underlying continues to move toward it. These can be ideal conditions for collecting fat premiums.
Again, however, only risk this if you have ample evidence that the fundamentals are on your side. Other types of volatility surges, such as weather events, are more fluid and require more caution. Those reports are solid and the market can adjust to them quickly. Weather is constantly changing and, thus, selling options in weather markets can get dicey, especially for beginners.
Many old-time traders favor the "Wall Street Journal Rule:" If a commodities story makes the front page of The Wall Street Journal, it’s time to fade the story. This is not a guaranteed strategy, of course, but it does provide an objective guide to selling options against the hype to collect bigger premiums.
6. Leg out of credit spreads
We are talking about strategies for maximizing premiums, not running the most effective, risk-averse options portfolio, so we will refrain from preaching the merits of credit spreads and instead offer just a brief tip for increasing your premiums from them.
A credit spread involves selling an option (or group of options) and then buying another option of lesser value to protect, or cover, your short option. Many credit spread sellers simply put them on and let them expire, keeping the credit (the difference between the two options) as profit. There is nothing wrong with this and it can be a conservative way to build a portfolio.
However, to squeeze a bit more profit out of your credit spread, try this: Sell your protection early. Once the short options in your credit spread have decayed by 70%-90%, the risk in them drops accordingly. This can be a good time to sell your protective options back to the market.
Obviously, those options will have decayed as well, but you will recapture some of the premium you paid for them. This can boost your overall return on the spread.
7. Use a professional floor trader
Option trading on commodities is one investment vehicle where using a floor trader in the pit still can offer you an advantage. Limit orders placed on commodities options through electronic markets often can sit unfilled unless a trade actually takes place that triggers a fill. In other words, a trade can’t work for you if it’s never filled.
Floor orders are actively worked by brokers. If your limit order does not get filled, a floor broker can give you an active bid/ask, something that does not always show up on an electronic screen. This is especially true in placing larger orders that floor brokers are motivated to fill.
A good floor broker sometimes can work the order for a better fill. More important, they sometimes can get filled on a ticket that might be overlooked in the electronic market.
Many traders view option writing as risky. As with all trading, there is risk. It is more accurate to say that option writing is a strategy that is easy to understand but difficult to master. Collecting the largest premiums should not always be your goal. To successfully manage an option-selling portfolio, you must balance premium collection with risk management.
Each method can boost your premiums. However, each comes with its own unique risk of implementation. One of these methods will not be right for every situation. These are a list of strategies and tools you can use. How you apply them will determine your performance.
James Cordier is the founder of Liberty Trading Group/OptionSellers.com. Michael Gross is an analyst with Liberty. They are the authors of "The Complete Guide to Option Selling," 2nd Edition (McGraw-Hill 2009). For more information on selling options, visit their website at www.OptionSellers.com.