A few weeks ago I wrote an article about one way to trade options instead of stocks, ETF’s and Futures markets.
Before I begin discussing the different income producing techniques that work when used correctly, I want to make sure you avoid one particular technique which is selling naked options.
Why is selling naked options is not an ideal technique to generate options income?
Selling naked options is the opposite of what options speculators do daily. Instead of being on the side that speculates on the direction of the market, the option seller needs to worry about time decay and where the market will not go instead.
To most beginners, especially those who’ve had little success trading stocks or other assets, selling options may appear like a worthwhile technique, the trader assumes that if the position goes against them, they can just quickly liquidate the trade and walk away from the loss, similarly to how it works with stock trading or with any type of market trading.
Options selling is very different in theory then in reality!
Unfortunately, anyone who’s had substantial experience with options, especially on the side of the seller will tell you that options are very different than stocks and many beginners don’t understand what GAMMA is or why it’s so important to understand, especially if you are the one who’s selling the options.
To put in simple terms, GAMMA is the measure of the change of the options Delta. The Delta is the amount or the percentage the Option moves for every dollar the stock moves, and the GAMMA tells the DELTA how fast to increase or decrease. The option’s gamma is a measure of the rate of change of its delta.
For example, lets say stock ABC is trading at $42 dollars and the $45 dollar call options is selling for $3.00 and assume the DELTA is 0.5 and the GAMMA is 0.4
If the stock moves up by about 10 percent, the delta will increase by about 15 % and will go from 0.65, the amount it’s increased is determined by the GAMMA. If the GAMMA is low, the DELTA may only increase by 8% and if the GAMMA is high, then the DELTA can increase by 20%.
So the GAMMA is what tells the DELTA how much to go up or down and GAMMA can REALLY move up really fast when the markets are moving up or volatility is strongly increasing.
Let me give you an example of something that actually happened to me while I was a futures broker several years ago. I had a client who was a beginner and was selling Natural Gas calls, they were very far out of the money and the odds of the market reaching that level was extremely unlikely. I would usually let clients write naked calls or puts if they were realistically going really far out of the money and this was the case here.
These options were being sold for about $300.00 premium per contract and to the best of my memory, the seller had only about 5 contracts that he was short, so the risk did not appear very large.
One day, the natural gas market exploded and AT the opening that day, each option that was sold for $300.00 premium was worth roughly $17,000 to $18,500 per contract (on average).
There was no time to get out of these options at night time and basically there was no way to mitigate risk on the position and this is something that could happen to stocks if earning are bad or to practically any commodity. So don’t feel that you can avoid what happened to me by using different assets or markets.
The options were still very far away from being in the money, so the increase was mostly time value, nonetheless, the GAMMA on the option increased several hundred times so before the move when Natural Gas would have a 1% move the option would increase by about .1% and after the move and increase the volatility, each 1% move increase by natural gas would increase the option by .9%. That’s the power of GAMMA and something you should be mindful of.
If you want to know what happened to the client? He declared Bankruptcy and I left holding the bag for about $80,000 when it was all said and done.
I remember taking my wife to the doctor who was pregnant with our second child later that day and thinking to myself that I could have bought her brand new Porsche with the money I lost today. (This was about 11 years ago)
That’s a true story and this is why selling options naked is described by professional traders as walking up the stairs and falling down, because what typically happens is the trader wins about 8 out of 10 times and breaks even on the 9th time and on the 10th time the trader loses everything he earned the first 9 times.
So remember when your selling options that the Delta doesn’t stay constant, it increases based on the GAMMA and that’s what you have to focus on.
Can I Sell Options to Generate Income Safely?
Now that I got that story out of my system, let me introduce to you a few ways professional traders actually trade options for income.
The first and the basis for all of these strategies is a Credit Spread which is a simple method of selling one call and buying a cheaper one in the same calendar month, one with a LOWER strike price and keeping the difference or the credit or alternatively, buying a put and selling a cheaper put, one with a LOWER strike price and keeping the difference between the two.
The reason why you buy the cheaper option is to protect yourself from what happened a few paragraphs above with the Natural Gas example I provided.
When selling credit spreads to generate consistent income, it’s best to sell an option that fairly close to the money and buy one that’s more out of the money, this way, the option that you sell will a higher premium, but at the same time will still have mostly time value