A discussion about selling premium

This weekend I wanted to spend a few minutes talking about the longer term charts, particularly the risk/reward of selling premium. For most of you the first part of this discussion is going to be old news, but I wanted to start with the basics to make sure the new readers would be able to follow along and to also lay the foundation for a strategy of selling premium in stages.

I am sure everyone is familiar with the basic abbreviations of ATM, ITM & OTM.

ATM – At The Money, this means the strike price of an option is the same as the price of the underlying stock/index. i.e. a 1450 SPX call would be ATM when the value of the spx is 1450.

ITM – In the money. For a call this means the strike price is below the value of the underlying, and for a put the strike is above the value of the underlying. i.e. A 1440 SPX call would be ITM when the SPX is at 1450.

OTM – Out of The Money. For a call the strike price is above the value of the underlying, and for a put the strike is below the value of the underlying. i.e. a 1480 SPX call would be OTM when the SPX is at 1450.

One of the first factors we want to look at is how much time do we sell. You could sell an option with a year’s worth of time, but would that be worth while? Normally the answer to that question is No. For most of the year the time value would ebb out at a very slow pace. When the option gets to around 6 to 8 weeks before expiration, then the time value starts eroding at a faster pace. This is one of the reasons why I created the monthly ranges where they are posted approximately 7 weeks before expiration, so they will be in this period of rapid erosion. In the final week the time value drains out of the option like the last bit of water draining out of a sink, you can see it swirl around and drop down the drain, which as an option seller is what you want to see.

So the best time to act on selling premium is when there are less than 8 weeks until expiration. One thing we have to look at is just how far OTM can we sell. We know that as we get to the final week the time value is draining very rapidly as the odds of the price moving very far from the ATM value decline, which means that the further OTM strikes will not have any value. This creates a double edged sword. As an option seller you have to move in close to the ATM value to be able to collect any premium. While the odds of a large move taking place in a short period of time are in favor of the option seller, there is the risk that the price could make that move. And because you are collecting such of a small amount of premium, the risk you face is one of the option acquiring real value, and more real value than the time value that you sold. In it in the 4 to 8 weeks prior to expiration that there is normally enough time value remaining to be able to sell a strike far enough away from the ATM value to make for a decent risk/reward picture.

There is a reason that we sell PREMIUM and not real value. When you sell the time value you are selling an OTM strike. The price of the underlying can move sideways, it can move away from the strike you sold, and it can even move towards the strike you sold, as long as the strike sold remain OTM there is not any real value to the strike, and on expiration day that OTM strike becomes worthless, where you keep all of the premium sold. When you sell an ITM strike, you have changed the dynamics of the position to one where the price of the underlying MUST move in your favor or you will be facing a loss as the real value of the option increases. This means you are facing a much higher risk factor right off the bat. Another downfall of selling an ITM option is that when we talk about selling options it is a given we are talking about selling a spread to control the risk, and also to keep the margin manageable. When you sell an option spread the maximum reward you can get is the premium that is sold, and most of the time your risk (amount of possible loss) is going to be as high or higher than the amount of premium that you collected. So when you sell an ITM spread, first the price must move in your favor, and no matter how big of a move it makes your reward is limited to the premium sold. If you feel you must sell an ITM strike, you may want to consider purchasing an option that would profit on a directional move, as this would give you a lower risk and a higher reward potential. It is because of the high risk and low reward that we do not want to sell an ITM option. Our goal is to sell TIME value, and the time of a strike that the price is unlikely to reach to change that strike from OTM to ATM or even ITM.

So far we have covered the philosophical basics. When we sell a call spread we want to sell a strike that is above the price of the underlying, far enough away that the underlying is unlikely to move up thru that strike in the 4 to 8 weeks of time that we sell. And for a put we want to sell a strike below the price of the underlying, and far enough away that the price of the underlying won’t fall below that strike in the targeted 4 to 8 weeks of time that we sell.

You can sell a call spread and/or you can sell a put spread. If you do both you have an Iron Condor. This creates a range that you expect the price to remain within up through expiration, marked with a top boundary of the call option sold and marked with a bottom boundary of the put option sold. One advantage of selling an iron condor is that you are selling both put and call premium, so you are collecting time value on both. On expiration day, if the price of the underlying does move too far to turn one of the strikes sold into an ITM option, it can only turn ONE SIDE ITM, not both. This helps to create a more favorable risk/reward scenario.

To get the best risk reward picture, when you sell the Iron Condor you must examine just how much premium you are getting on EACH side of the position. For sake of argument we will use the SPX value of 1450, and say we are going to sell the 1500 call and 1400 put with 6 weeks of time value remaining. (Yes we will sell spreads, say the 1500/1510 call spread and 1390/1400 put spread). Let’s say that for the entire Iron Condor position we collect $2.80 in premium. (I am not using actual option prices for this example.) The risk is that the price moves up past 1500, OR that it moves down below 1400, and our risk is limited to the distance of the spread, 10 points, minus the premium collected. If we examine how much of that $2.80 is coming from selling the call spread and find that it is $2.65 and we are only getting 25¢ from selling the put spread, why would we want to enter the entire Iron Condor as one position at this time? Does the 25¢ from the put spread change the risk/reward factor enough to make it worth while?

The prices used in that example are purely hypothetical. Perhaps we would get the $2.65 by selling the put spread and only a quarter for selling the call spread. The point I am trying to make is that we need to know just how much premium each side of the position is generating to determine if the whole position makes sense to enter. Many times the amount of call premium and amount of put premium will be fairly close to the same, and the overall position would be worthwhile based on the premium collected on each side.

When it is heavily skewed to one side, then we would need to serious reconsider our choice of position and think long and hard about just selling a “leg”, where we only sell the option that is generating the bulk of the premium. You then wait for the next move to take place and sell the other “leg” to complete the Iron Condor, and generally receiving more premium on each side, and a lower risk.

In the above example I used the 1400 and 1500 strikes to be sold just because they represented a nice even amount of distance on each side of the price current 1450 price. This brings us to the discussion of how do we select what OTM strike to sell?

One method is to find support and resistance on the chart, and sell a call spread at or just above resistance and sell a put spread at or just below support. The thought behind this is that the support or resistance stopped a directional move in the past and has the prospects to do so again. The risk of using the support or resistance level is moderately high though, as it is not uncommon for the price to “peek” beyond the support or resistance when that level is being tested. If you use the support or resistance level and the price “peeks” beyond it, then your sold strike becomes ITM and also starts causing pain as it is becoming a losing position. This could cause you to stop out for a loss, because once your strike is hit the risk is that a breakout or breakdown is occurring and you want to prevent your position from turning into a large loss. But when all the price does is “peek” thru that support or resistance, you stop out only to see the price shoot right back above the support or below the resistance as that support or resistance exerts it’s influence on the price. This would be prevented by selecting a strike beyond that support or resistance level to reduce your risk of that “peek” hitting your stop, and this way it would also make sure the breakout or breakdown is taking place which would then threaten your strike sold and give you time to take corrective action before a large loss is created.

There are different probability calculators that give the odds on how the odds of the price moving an amount of distance from where it is currently at. The biggest pit fall with these calculators is that the “target” changes along with a change of the underlying stock/index price. On the SPX it is possible that today there may be a 70% probability that the price would remain below 1500, but during the day if the SPX moves up to say 1470, then the odds may only show a 40% probability of it remaining below 1500. So you have a moving “target” to use, which undermines the confidence of the “target” level as one to sell premium at.

For the past 2 years I have been posting monthly ranges on the ndx, djx, & spx, and during this time added ranges for the rut and xeo. These ranges posted are static and are based on an algorithm I created. This process uses the monthly chart and on the first trading day of the month gives us a level that the price is likely to remain within up to the following months expiration, giving us approximately 7 weeks of time. One benefit of these monthly ranges is that it defines a level the price is unlikely to move past when there is a directional move during those 7 weeks. On Jan 3rd I posted the ranges for the Feb expiration. On the spx the top of that monthly range is 1470. For most of Jan the price remained in a tight trading range between 1405 and 1440, a 35 point range. This past week the price broke out thru the resistance as it moved from the 1420 level up to 1450. A 30 point move in one week, and it is now within “striking” distance of that 1470 level, IF this move continues. One thing to think about is after 4 weeks of the price remaining within a 35 point range, how likely is it that we will see 2 or 3 weeks where it covers 30 points per week, without any pullback? Yes it is possible, as we do have a directional move in progress. And yes this past fall we had 3 months in a row where the prices did make some strong moves to bruise the overall track record of the monthly ranges, so it does happen. However for the past 2 months the prices have remained within the ranges and so far this month the prices are still within the ranges posted. It is when the price is nearing one of the monthly ranges that we would find the discrepancy in the amount of premium sold vary when we use the monthly ranges as the basis for an Iron Condor position. Such as when the price is near the top of a monthly range, and we use a strike at or just above the top of the range for the sold call spread, we would collect much more premium on the calls. Because the put spread is so far away from the bottom of the monthly range, and so far OTM, there would hardly be any premium to collect on selling that put spread.

This brings us to the risk/reward conditions that I examine in the Market Analysis Reports for the longer term charts as they pertain to selling premium. Instead of looking at a whole Iron Condor position the focus is on the “legs” where we look at selling either a call spread or a put spread.

As the price nears one of the boundaries of the monthly ranges it is telling us that the directional move is most likely becoming extended and the odds are high that the move is nearing and end. This tells us that when the price is near the top of the ranges we would want to look to sell a call spread, and when it is near the bottom of the range to sell a put spread. Like any indicator we do not rely on the price being near one of the boundaries as the sole reason to enter a position. As the price approaches one of the boundaries we have a directional move taking place, and just like a move to a support or resistance level there is some risk that the move could continue and “peek” or break thru the key level. This creates a higher level of risk of selling that leg until we actually see indications that the directional move is beginning to falter or stall, and then the conditions would quickly shift to favorable to sell the OTM spread, using a strike at or beyond the monthly range. The best time to sell a leg is when a directional move is ending. The reason for this is that with the directional move people are buying options expecting that move to continue, which bids up the price of the options and allows you to collect more premium. Also, once that move does end, and people realize that it is not going to continue, the demand for those options disappears and the price of the option falls quickly, which helps reduce the risk of the position you took ahead of the crowd.

With a directional move, people are buying the options that go along with that move, such as with an upward move people are generally buying calls, and there is not a demand for puts, which makes it doubly hard to be able to collect enough premium on a put spread to make it worth while in selling one. The other problem is that with a directional move the underlying stock/index is moving away from one of the boundaries and as that boundary gets further OTM the price of that strike decreases to where they just isn’t any premium to collect.

This tells us that there are times when a directional move is underway that the risk of selling premium is high. When an upward move is underway the risk is that the move could continue, so you don’t want to sell a call spread until the move begins to stall or falter, which signifies the move is ending. Also because the price is moving away from the bottom of the range that strike is becoming further and further OTM and would generate less premium, making the low reward not worth the risk. To use a strike above the bottom of the range for a sold put spread you increase the risk that a reversal could drop the price down thru the strike sold. The same principles apply when the price is falling. You need to wait for the drop to come to an end before selling a put spread, as the risk is that the move could continue and move thru the strike you sold. As the price drops it is moving further away from the top of the range, and the price of that strike is decreasing rapidly leaving you with very little premium to collect, which creates a small reward. To use a strike below the top of the range increases the risk as a reversal in price could move up thru the strike you sold. So when there is a directional move taking place we need to focus on the shorter term charts and look for the early indications of when that move begins to end, so we can get in front of the crowd to sell premium, and collect as much of the premium that we can before “everyone” realizes the move has ended.

We look for multiple indications to determine when the best conditions (odds) are showing to sell premium. We look to see if the price is closer to one boundary than the other, we look for overbought or oversold conditions on the different time frames, and we also look at the longer term conditions of strength/weakness in the price and trend. Once we see multiple conditions developing we can then use the shorter term charts to help to identify the best time to consider selling a spread to collect as much premium as possible with a favorable risk/reward situation. This is based on odds, and we are looking to put the odds in our favor that a directional move is ending, which gives us the prospects to sell either a call spread or a put spread as the prospects are high that the price will either stall and move sideways or move in our “favor” to erode the premium sold even faster. There will be times when a position just does not work out, so we do have to use money management techniques and manage the account and positions to ensure that when a position does not work out it does not result in a crippling large loss.

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