When selling options, often I get a question or inquiry from members of our community with regard to how far out-of-the-money we should sell our options and set our positions. Now, I typically target around the 70% probability of success area for my short option selling trades, but others have often wondered that if given the choice why we don't just sell options at the 90% probability of success level? I mean if 70% is good, 90% has to be better right?
Well, it's clearly not that easy. As you go further and further OTM selling options, the premiums you receive erode quickly. This begs the question, are you selling options too cheap or do you actually need to take more risk and come a little close in when selling? In today's show we'll dive deep into this question and present two different case studies which might help shed light on the topic.
Key Points from Today's Show:
- What is the optimal level at which you should be selling options?
- There is no one right answer, because the optimal range varies with each trade.
- However, there is a distinction between trading at a 70% and 90% success level.
- When selling at the 90% success level, you are simple not collecting enough premium to make it worth it.
- If you factor in commissions and trading costs, the 90% level does not generate a lot of return.
- You have to determine what is more important to you: win rate, or return?
SPY September Call Option: A Case Study
- 40 Deltas are trading for $235, slightly out of the money.
- 30 Deltas are trading for $140, 10% more out of the money and a 40% drop in premium.
- 20 Deltas are trading for $75, a 46% reduction in premium.
- 10 Deltas are trading for $26, which is a 65% reduction in the premium.
- As you move further out of the money, option values and premiums decrease at a more significant rate.
- Continuing to go further out of the money, you increase your probability of success but sacrifice the premium you collect.
- It is important to understand the trade off: premium versus level of success.
- The key is finding the optimum level of risk and reward where you capture enough premium, but are just far enough out to obtain a significant win rate.
- A comfortable level (confirmed by backtesting) is the 70% success level.
Back Testing Case Study: Short Strangles, 60 Days to Expiration
- Low volatility, 60 days until expiration, short strangle.
- The best Delta in most cases is around a 20 Delta on each side.
- Overall, you want to choose a strategy that has the mechanics of a stable portfolio.