Most of the investors are inclined towards the options because it offers a great source of income generation. Call and Put strategies help an investor to generate income and hedge the risk of their portfolio.
What is Options Trading?
Options are the contracts that give the holder the right but not an obligation to buy or sell the stock of an underlying asset at the strike price on or before the expiration date. The call option gives the buyer the right to buy while the put option gives the right to sell. The option seller(writer) receives the premium amount for selling this right to the buyer. Investors are attracted towards writing options as the premium is a non-refundable amount irrespective of the buyer exercises its right or not.
Based on a CME study of expiring and exercised options covering three years (1997, 1998, and 1999), an average of 76.5% of all options held to expiration at the Chicago Mercantile Exchange expired worthless. The put seller has the advantage of generating income on a worthless expired contract and also an opportunity to buy the shares at an attractive price if the buyer exercised its right. Selling weekly puts enable the sellers to trade four times a month and generate higher annualized returns on investment.
When to sell weekly puts?
Following points to be considered while selling weekly puts
If the seller has a bullish or neutral view on the stock of an underlying, he can sell put options with an attractive premium amount.
The seller should sell the put option when the trend is range-bound or there is a slow movement of the stock. It ensures the stock will move in a particular range.
Selling weekly puts can be beneficial when the volatility of stock of an underlying asset is lower to avoid huge losses if the stock moves in the opposite direction.
There should be a sufficient margin in the account to place a selling order. The capital requirement varies from broker to broker.
Premium amount should be attractive to cover the cost of the transaction and generate significant returns on the option.
Advantages of selling weekly puts
- Time decay
Time decay accelerates as an option’s time to expiration draws closer since there’s less time to realize a profit from the trade. The put seller gets a regular premium amount on every expired day. We calculate the time factor by options greek called theta. Selling weekly puts allows the traders to take advantage of a faster rate of premium declination.
- Odds in favor
There is a greater possibility that the contract expires worthless on the expiration day and the seller generates income on premium. Maximum times the seller gets the benefit of the likelihood of the outcome.
Let us suppose the stock of the XYZ company is traded at $50 and has an IV of 20%. The expected range of the stock’s movement is $40- $60(20% 0f $50), about 68% of times the stock will move in this range.
- Trading Edge
Generally, the option pricing is overstated in the long term because IV(implied volatility) usually overstates the expected move of an underlying stock, ETF, Index. IV is derived from options pricing. It is a future projection of the movement of the stock. Market overestimates the implied volatility than the realized volatility. In the DIA(SPDR Dow Jones Industrial Average) study on historical IV(HIV) and realized IV it was found that there was a 6.25% difference in HIV and actual IV. On average, the DIA expected the market to have a slightly more volatile environment than has been realized over the last 13 years. As implied volatility increases(vega) an options price will increase to compensate for the higher probability of being ITM at expiry. Because of the overestimation of implied volatility, the cost of options increases, and the buyer pays more than the actual risk undertaken by the seller. The seller gets edged on the transaction and receives a higher premium than the actual risk associated with the stock.
- Buying a stock at an attractive price
The seller gets a chance to buy the stock of the company at an attractive price if the buyer exercises its right and sell the underlying stock at the strike price. The buyer exercises its right if the spot price is lower than the strike price. The put seller has an obligation to buy the shares at the strike price higher than the market price. Though the seller suffers the loss to buy at the higher price he receives the shares at the attractive price. He can hold the shares and sell them at a higher price in the future. Stocks of blue-chip companies having the potential to move up in the future are recommended to hold.
Though option sellers have unlimited risk and limited profit opportunities on the contracts, they can hedge their position by combining other strategies and can limit their risk. Sellers can professionally manage their risk with cash secured puts, bull put spreads, covered calls, calendar spreads, etc. Selling naked puts increase the potential risk of the portfolio so, it is advisable to carefully study the market and combine various strategies to limit the potential risk.
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