The pros know that option trading is really about trading volatility more than anything else. While option values can also be influenced by market movements and time, successful options traders know the key to trading options is to buy relatively cheap or under priced options and sell relatively expensive or overpriced options.
That being said, you have to know how to determine whether or not an option is relatively expensive, cheap or near fair theoretical value, but that discussion is for another time.
Let’s focus on three simple ways to sell overpriced option premiums.
Sell Cash Secured Puts
The key here is to sell cash-secured puts on a stock that you aren’t really keen on owning. Let’s assume for a moment that you own shares of stock ABC which is currently trading at $30 per share. However, you’d rather own it if it’s at $26 instead. You may want to consider writing a cash-secured put for every 100 shares of stock you would be comfortable owning if the stock exhibits some volatility. If the stock has seen prior support at the $27 level, you could look to sell at $26 put if the shares pull back.
The puts may become over inflated on such a pullback as investors who are long on the stock get nervous and scramble to buy puts to protect their long positions. If you sell a $26 put and the stock moves back up, your put may expire worthless and you keep the premium collected.
In contrast, if the stock moves below the $26 strike price at expiration, you may be assigned a long position in the shares from $26-a position you already decided you wouldn’t mind having. Plus, you still keep the premium collected.
Sell On Stock Market Declines
You could look to sell put premium on stock market declines of 10 percent or more using index products such as the SPX or SPY. While double digit declines don’t occur frequently, they do happen and may present opportunities to sell highly overvalued put premiums. For example, if the S&P 500 gaps lower and opens the trading day down 40 or 50 handles, investors may be scrambling to buy puts to hedge their portfolios. These investors are willing to pay up to do so.
In such a scenario, you might consider the sale of a put spread. For example, if the S&P opens lower by 50 points at 1990, you may be able to sell put spreads that are another 5 to 10 percent out-of-the-money or more and receive a decent premium for the risk you are taking. If you were instead to sell a 1890/1900 put spread on the SPX, the market would have to move another five percent plus for your spread to go in the money.
While the risk of loss certainly exists, the spread could potentially profit if implied volatility levels decline or the passage of time erodes the option values. If the market is above the short strike of 1890 at expiration, you keep the premium collected.
Sell Iron Condors
The key is to sell iron condors on markets whose implied volatility levels are at or near their six or 12 month highs. While many people might associate the iron condor with a range-bound market, the strategy can also be very useful for capturing over-inflated option premiums.
Often times, IV levels will rise in an options market due to an upcoming announcement such as earnings. For example, stock XYZ may have traded in a range for the last two months yet its option values are trading near the high end of their six month IV range. This may be due to an upcoming earnings announcement set for release in a few weeks.
You think that the announcement will likely be a non-event and the stock will continue to trade within its current range. In this case, you might consider selling an iron condor. With shares of XYZ currently at $45 per share, you might consider something like selling the front month $50/$55 call spread and front month $35/$40 put spread.
If the option values are overvalued, you may potentially profit from mean reversion in IV levels. You could also potentially profit from time decay as well. If the stock is between the short strikes or $40 and $50 at expiration, all options will expire worthless and you keep the premium collected.
Options can be used in many other ways in an attempt to capture over-inflated premiums. Other strategies such as ratio spreads, covered calls and iron butterflies may all potentially offer a method for collecting rich option premiums. To be successful using such strategies, you must become intimately familiar with implied volatility, risk management and option mechanics.
It should go without saying that all of these strategies carry risk. Markets can and do make extended moves that appear to defy logic. While the opportunity for profit exists, so does an equal or even greater opportunity for loss. Always make sure you understand the risks involved with any type of strategy or trade before doing it. If you aren’t willing to assume those risks-which in some cases may be unlimited – you may want to stick with defined risk strategies.