This article originally ran on Traders Reserve
Let’s delve a bit into one of the more advanced options concepts — selling time premium.
Traders that are new to options often begin with just Call/Put purchasing and perhaps covered calls. Then they begin to wonder what the other side of the options transaction is like. Remember that for every single listed option trade, there is a buyer and a seller — usually it’s the public buying options and the Market Makers handling the order flow and maintaining an orderly two-sided market.
One to two weeks before monthly options expiration (the new Weekly options are a whole other story) is often a very attractive time to sell option premium due to the rapid decay that will occur by expiration Friday. First, I’m generally not a fan of ever selling “naked” options (not covered by another option or underlying) … unless perhaps you run a giant hedge fund. Your risk can be unlimited, the margins are very high and you can have 10 winners in a row and one big loser can wipe out all your profits and more. So one of my preferred ways to garner that rapid decay in time premium and Theta is to sell front month out-of-the-money (OTM) call or put spreads ahead of expiration. This is known as a Credit Spread, also a Vertical Call or Put Spread, and it’s a great way to collect cash using options.
The “spread” part means that we are selling one option and buying another in the same amount, in one simultaneous transaction and receive a net “credit” (cash) for the trade. So if you are looking at doing this, you need to find a stock/index/ETF that will either go your direction OR be flat heading into expiration. The nice thing about credit spreads is that you get a “cushion” within which the security can move against you and you can still make the maximum profit on it.
Here is a recent real-life example with real prices from a week ago — the SPDR S&P 500 Index ETF (NYSE: SPY), which basically mimics 1/10 the performance of the S&P 500 Index (SPX). Let’s assume you were bullish/neutral on the SPYders heading into the final trading day for January options. At that time SPY was at 128.50. The SPY has one-point increments on its strike prices and is very liquid with small bid/ask spreads, so securities like this are particularly attractive to sell premium on — you don’t give up as much “edge” to the market makers with wide big/ask spreads and execution problems. And while the SPY itself is fairly high-priced for a stock, being above 100, the implied volatilities on its January options really aren’t that high. The at-the-money (ATM) straddle was only trading around a13% implied volatility. So with our Bullish/Neutral theoretical stance (not a trade recommendation), we would be looking at January out-of-the-money (OTM) put spreads to sell.
If one is banking that the SPX itself will go out above the key 1,250 level, we could look at selling the SPY Jan 125/124 Put spread. Currently, this spread is 0.07 by 0.11 — the maximum risk is the premium received minus the difference between the strikes — so in this case if we sold it at 8 cents, the max risk is 92 cents. That’s a 8.7% return on risk in 1.5 weeks, also with a price cushion of approximately 3.6 points on the SPY to breakeven level of 125 (around 2.8% downside protection). That return is a bit lower than I usually prefer for my front-month credit spreads (I prefer 15% to 60% maximum potential gains), but since 125 is such a key technical/psychological level, let’s just use this as a theoretical example.
Basically in this case, if we sold this 1 point spread for 0.08 ($8), then $92 is required for each spread by most brokers as the margin required (maximum risk). If the stock goes out above 125, the two options expire worthless and you keep the $8 credit received for a quick gain. You also have that cushion whereby the SPY can go almost 3% against you and you’ll still profit. That’s why credit spreads in this manner have a high probability of success – so you don’t have to be correct in your directional pick, you just can’t be dead wrong. Your own personal risk/reward comfort level should help determine what spreads you feel most comfortable selling.