Option Writing - Learn To Collect Option Premiums Safely

It's no secret that I favor and mainly trading strategies that are focused on option writing. And if you learn to use these strategies you can also start collecting option premiums safely each month.

A great feature of options is that they not only allow you to make money on directional plays, they also allow you to profit when stocks don’t move. Since I've very risk adverse and conservative in my own trading, I prefer option writing to any other strategy.

Of course I'm not naive enough to believe that this is the only strategy I should use. Depending on market conditions I will buy options from time to time for both speculating and hedging purposes.

But the if you are horrible at picking the market direction, then the only way you can take advantage of the lack of movement in a stock (or even the wrong movement) is buy writing options and collecting option premiums.

Understanding The Real Risks

When writing or selling options, you have to clearly understand that you are short an option and technically speaking have an unlimited potential risk position. I however beg to differ on this point and I'll show you why here.

Option writing also has the "unlimited risk" stigma that's attached to it. But let's think about where this comes from. You see if you are short a Call option your risk is that the stock continues higher forever right? Well if you trade the indexes (like I do) then there is of course limited upside potential.

Trading The Indexes Are Safer Than Stocks

Sure the markets can mach higher but making 20% or even 50% gains in a given month never happens - ever. So the critics will say that option selling has unlimited risk but only if the indexes go higher forever. And since we typically trade only 1-2 months out we have all but dispelled this myth. There just isn't enough time for them to make these kinds of moves.

I cannot however say the same for individual stocks. If you dare trade these then you absolutely run the risk of major overnight moves that are company specific; bankruptcy, merger, buy-out, etc. Stick to the indexes and you will reduce this gaping risk dramatically.

4 Keys To Writing Options

Now that I have given you your risk disclosure, I want to give you some keys to successful premium collection each month for income.

  1. STICK TO THE INDEXES - I've already gone over this one but it's worth mentioning again. With the indexes you do not have the company specific risk like regular stocks have. The indexes are a compilation of other stocks and thus 1 or 2 bad eggs won't spoil the whole group. Besides the indexes are more liquid for better fills and pricing.
  2. TRADE DEEP OUT-OF-THE MONEY - Don't get too close to the market with your strike prices. Try to get as far away as possible each month and give yourself room for error. Sure you may take a slightly lower return but you will absolutely be much more consistent each month.
  3. EXIT EARLY WHEN POSSIBLE - If you made a great trade and sold an option for a higher premium, get out of the trade early if the options has decayed. For example, if you sold an option for $80 and now it's worth $5, why hold onto this position for another $5? Move on and take the profit!
  4. SELL DURING PERIODS OF HIGH VOLATILITY - Spikes in the VIX present amazing opportunities for option sellers. When volatility spikes, option premiums swell and you are able to sell options much further from the market's current price. Since these periods don't last long you can see dramatic drops premiums in a very short time which can give you quick profits.

What Has Worked For You?

Throughout your own trading career, what tips and tricks have worked for you? I don’t care whether you are a newbie or an expert please leave a comment as I’d love you know your thoughts.

  • Matt

    I've found personally it's all about having enough money for margin. I've profitably traded for 2 years, yet I've had my margin raised 4 times by 2 different firms this year. It doesn't matter if you have a profitable naked option selling strategy. You need a brokerage firm that won't raise your margin requirements because they don't understand the risks.

    • http://optionalpha.com/ Kirk Du Plessis

      Hey Matt! Very true - risk can be managed on the brokerage end if the understand how it works.

      Kirk Du Plessis

  • Aaron

    Kirk, very good article here on selling. What are your thoughts on selling weeklies? have you had success? I've been using my demo account on weeklies with about 10K and so far it's been working quite well. But I don't know if it's luck or what because the profits just seems too good to be true so I'm kinda hesitant on putting in my cash.

    • http://optionalpha.com/ Kirk Du Plessis

      They are okay if you can get the premium out of them. Mostly I use them for earnings.

  • Joshua

    When u say indexes, I assume u refer to ETFs mainly.

    However, I use this same strategy on financial futures and commodity futures. Have u tried that? I find my return on index ETFs too low.

    • http://optionalpha.com/ Kirk Du Plessis

      Yes and indexes like SPX, RUT, NDX also.