The Skinny on Fat Option Premiums

Since I like to sell options, it would be a worthwhile
exercise to explain

what the best conditions are for options selling. After all, if you

selling premium, which by definition implies, limited profit, the fatter the

premium, the fatter the potential profits. So what are “fat” premiums?

Options have what are known as theoretical prices, so-called fair value

prices. Given a pricing model like Black-Scholes, you put in the variable

data (like strike, time to expiration, and statistical volatility) and out

comes a price. But what you find is that actual market prices are not always

the same as these theoretical values. If you are planning to sell an option,

a good condition to have on your side is market prices above theoretical,

just for starters.

Assume, for example, that we have fair value from an options pricing model

like Black-Scholes, and we find that the option prices in the market are

higher than the model prices; you then have what are known as options that

are “over-valued” in terms of the model (of course this assumes the model is

correctly specified).

One of the key variables in the model is recent volatility of the

underlying, so if underlying volatility has been low but option traders are

expecting more volatility just ahead, they may be bidding that volatility

into current prices for options. While actual prices may be theoretically

incorrect, the market often knows best, and volatility may suddenly

increase, suggesting the model was wrong.

In any case, if we assume that the model is correctly specified, and actual

market prices are well above theoretical prices, we may consider that the

options are over-valued, a necessary condition for selling.

More importantly, though, if the level of the implied volatility (derived

from the model by plugging in actual prices and actual volatility and then

computing solving the equations backwards) is at an extreme high level

relative to past levels, a reversion to the mean reaction may occur,

suggesting this is a good time to both sell options and sell volatility.

This is a second definition of a “fat” premium for selling.

So, ideally, when looking at options for selling, you want to be looking at

both the levels of implied and statistical volatility relative to their

respective past levels (which defines “cheap” versus “expensive”), and

levels of implied and statistical volatility relative to each other (the

over- and under-valued dimension). Both are important and given both

over-valued and expensive options, you have two conditions that

traditionally have defined “fat” premiums. If you are a buyer, you had

better be careful about paying for these options, for the reasons sellers

want to sell them.

By looking at high and low ranges in a given time frame, say over six years,

we can thus identify the following two key conditions for possibly selling


1. Implied volatility should be greater than current levels of statistical


2. Implied and statistical volatility should be in their 90th or higher


By using these two conditions as a screen, while not any automatic trader

finder method, you should be able to narrow down the number of possible of

trades, from which you can then drill down to the best possible setups.


Have a great trading day!

John Summa, CTA, CPO

Founder & President

John F. Summa is Founder and President of
and a registered Commodity Trading Advisor (CTA) with the National Futures
Association (NFA). Founded in 1998, offers trading
seminars and tutorials to options traders, futures and option trading
advisories and managed futures and options CTA account services.

Summa’s trading articles have appeared in Technical Analysis of Stocks &
Commodities magazine, as well as Active Trader Magazine, Options Trader
Magazine, Futures Magazine, Stock, Futures & Options Magazine, and He coauthored

Options on Futures: New
Trading Strategies and Options on Futures Workbook
(John Wiley & Sons, 2001) and more recently wrote the groundbreaking
Against The Crowd: Profiting From Fear and Greed in Stock, Futures and
Options Markets
(John Wiley & Sons,
2004), which includes Mr. Summa’s innovative quantitative bear and bull
news-flow Contrarian indicator.

Mr. Summa is a PhD-trained economist
and operates a
delta-neutral options trading CTA program.