Everything You Need to Know About Options Selling
I want to coin the term “Behavioral Trading”, which I define as inefficiencies in the markets based on extreme human reactions to news, price, or expectations that are often overdone because of natural human responses.
On average, the more recent, the more extreme, and the more vivid or tangible an event is — the more excitable our brains are to it. And, that works with both scary events such as a plane crash or stock market crash, and with happy events such as winning the lottery or having your most recent stock pick double in 3 days.
The interesting part of this is that these neuro-humoral responses do not take into account the probabilities of these events actually happening. In fact our brains actually short circuit from a probability standpoint in these extreme circumstances which is unfortunate when it comes to the stock market because the entire (stock market) game is based on how much risk you are willing to buy for a given price.
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All of this explains why more people are willing to play slot machines (where you see people winning big prizes all over the casino floor) with worse actual odds relative to risk than play at the blackjack table playing a simple system where there is no big excitement (but better odds). It also explains why people are more scared of dying in a plane crash than an auto accident. So what does this have to do with options? And, how can we make money from it?
As most people reading this know, there are two parts to option pricing; there is the intrinsic value, or real value, and there is the premium, or what I like to call the “fluff”.
I’ve written about this in a prior blog post here… to get a little refresher. When you buy options you want to buy as little “fluff” as possible, and when you sell, you essentially want to sell as much “fluff” as possible. The trick is to understand when there is just too much “fluff”. If there is, then you want to sell the option. That easy.
Here is the next part to know, the prices of options, (which for this post we are just talking about options premium) are based on popularity. Everyone asks me how come when a stock goes up, the volatility index, or the options’ premium goes down, but when a stock goes down the “volatility” or premium seems to go up, and thus the “fluff” of the options goes up.
That doesn’t make any sense if options were priced on volatility alone. Think about it, it shouldn’t matter if the stock goes up or down an equal amount in determining the premium on an option (up volatility should be priced the same as down volatility), if that option premium was just based on volatility.
What is happening is that when a lot of people want puts — the price goes up. When a lot of people want calls – the price goes up. Fear is a bigger driver of action in people than excitement (except in extreme cases). Thus, when the market is going straight down — we all want insurance or puts. When the market is going up nicely, and everything seems safe, no one wants insurance — (you just can’t envision a catastrophe). Furthermore, it is hard to imagine something really great happening (not a lot of call buyer), unless it just happened (then it becomes very tangible, and therefore probable in our minds).
The most ironic part is that our brains are hard wired to think that just after something just happened that is the time that is the most likely to happen again. Just the opposite. When a company misses earning and drops 30% — that information is now in the stock. Yes, there may be some further selling for new information that comes out, and people who sell, because they think that that event is likely to happen again. But, in actuality — it is not true. Most of the time when we think that the sky is falling, in the end, it doesn’t fall. Not always, but usually.
So, now, how do we use this? Well, now that we know that the “fluff” is what we want to be selling. We need to find options that have the least chance of ever having “intrinsic value.” That means option strikes that are well out of the money. How out of the money? I like at least 20% out of the money.
Now, just because an option is 20% out of the money does not mean it is a good sell, it very well maybe. But, I like to use “Behavioral Trading” to make sure that I am taking advantage of the bad wiring in people’s brains. Because it is entirely possible that 20% of out of the money options that sell for 0.20, may cost you 0.80 in 1 in 5 trades (which would mean that after every 4 winners of 0.20, you would lose 0.80, thus, you not be making any money, but you would be getting an interest free loan). We don’t want that – we want to sell options when people are overpaying for them relative to the chance that they lose money.
The most likely chance of that is after the most tangible fear or excitement — that is when people are willing to pay. Think, when the hurricane is off the coast — I will pay anything for flood insurance, yes, the hurricane is more likely, but people are willing to pay even more than than the correct price (based on statistics).
Let’s look at an example of the hurricane being off the coast.
Notice the RAPID collapse in the SPY in January–this triggers lots of fear.
The above chart is of the June, 2007 September 115 Puts.
This is an example of when the event is tangible, extreme, and recent, people are willing to pay extra for the “fluff.” Now, some people may be thinking, it is still very possible that that option becomes a loser as we move down to a 20+% loss on the market over the next few months. And, that may be true, but you don’t have to hold the option til’ expiration. That is another mis-pricing in the system. The options are priced for where everything will be at expiration, but you have the right to get out anytime you want. And, when the market is barreling in one direction or another over several days, it is extremely unlikely that it continues in the short term at the same rate.
However, the option is now pricing in that rate, and people are paying for that rate of decent. As soon as the underlying pauses, people will not be willing to pay that much “fluff” or premium, just look at the chart above. From an overall standpoint, I could make an argument that 2 days later this option has an equally good chance of ending up in the money in June as on Jan 22nd, but the price of the option was 50% cheaper. The main thing that was different was that the vividness and recency of the terror was dwindling–right along with the price. Therefore, as soon as the underlying pauses or goes in the favorable direction for you–it is time to buy it back. Whether it is a winner or a loser at that point. You are trying to sell terror or bliss and buy it back as soon as it abates.
The next trick to this is position sizing which is critical. Because as good as this sounds, you will lose sometimes, and, although most of the losses will be small, on occasion, some losses will be big. You must avoid both corporate and sector risk. The bottom line is that sometimes when it looks like the sky is falling (and you sell the option), it really does end up falling (and you lose big). As a comparison, casino’s have an edge in their casino’s, and despite this, every once in a while someone wins a 10 million dollar jackpot.
Despite the casino’s misfortune, they still continue to deal blackjack hands, and they leave the other slot machines on. The only way they can do this, is if their risk (the 10 million dollar jackpot) does not put them out of business–In other words, a big loser must still allow you to keep trading (so it must be small relative to your account size). Therefore, I recommend basing the amount of option contracts to sell on 2.5-3% of the underlying value. Thus, if you have a 100,000 dollar account, 3% is 3000.00. So, if you are trading options on a 30 dollar stock, I recommend just selling 1 contract (100 shares per contract x 30). Additionally, I recommend selling options about 4-8 weeks out.
This allows you to get some premium on contracts that are far enough out of the money that you are unlikely to ever be trading with intrinsic value. Also, “some premium” is at least 0.30 because I recommend that you always have a “good ’til cancel” buy order in, and the least amount that you can buy the options back is usually about 0.10 to 015 cents. Therefore, you should at least sell the contracts for 0.30. Now, this may not sound like a whole lot of money, but you can do this on 20-30 positions (max) and the trades are usually fairly short in duration (2-5 days) so it can be done over and over again on different stocks.
Essentially, it works out that you have lots of small winners with a very small amount of larger losers, and the net effect equals about 1-2% a month with very minimal risk. Additionally, if you are already trading a long strategy–you can just do this by going short calls and therefore getting some short exposure while your money would have been sitting idle. Overall, there is a wonderful edge here; you just need to make sure and not get carried away with large position sizes so that you can take advantage of it.
All you have to do is just sell the “fluff”.
Steven Gabriel is a self-taught trader who primarily swing trades for his own account from his home in Orange County, California. Steven has been trading for 8 years and is a systematic trader. He uses stocks, single stock futures, options, and e-mini’s for both risk control and leverage. Steven is also a board-certified physician in Emergency Medicine and still practices medicine in southern CA. You can contact him at stevengabriel@mac.com.