Podcast – Episode 015 – Option Selling Defined
So what is option selling?
Hey There Genius Nation. Hopefully the market have been kind to you so far this year.
In today’s episode I wanted to talk about what option selling is.
I realized that we have done many episodes already where we talk about why you should be selling options, but never gave an explanation.
Now you might already know, that I run an options trading advisory called optiongenius.com
This is a membership where people pay to get access to my trades. So if you want to see how I trade options, you can become a member and see them for yourself.
Now when we first started the site, the headline was $1 Is All is takes to make 8-12% a month!
Because at that time, we were offering the first month for membership for just $1. And potentially with our trades you can make 8-12% a month.
Now of course there will be some losing month, but even with those, there have been years where we have made over 100% a year.
The problem is that most people don’t believe it. Most people don’t believe you can make 10% a month because they have never heard of trading options the way we do it.
And these people happen to work at large companies like Google and Facebook.
So here we were, growing like crazy, hundreds of people joining our site every month, when I guess we got too big. So Goog reached out to us and told us to tone down our marketing. Well they didn’t say that, they just shut off all our ads with no notice.
When we were finally able to contact someone about it, they said they didn’t believe us, even though we had plenty of proof and testimonials.
They made us use “safer” language to explain what we do.
So here is the definition of what an option seller does, as approved by Google:
OptionGenius.com uses a market neutral strategy. This strategy takes advantage of market reality; short term market direction is extremely difficult to predict. What we do is similar to what insurance companies do. Insurance companies profit from highly sophisticated probability models in order to collect more in insurance premiums than they pay out in claims. This results in most people paying more money in insurance premiums than they ever receive in claims. Similarly, option buyers often pay more in option premiums than the profits they receive, losing money in the long run. Our market neutral strategy aims to take advantage of this by collecting option premiums while actively managing risk. This strategy uses high probability hedging methodologies to generate option income. Positive returns are generated, independent of market direction, through equity and index option structures with well defined risk option strategies. Probability models and strict trading disciplines have been implemented to improve the risk/reward characteristics and increase overall returns.
Thanks google, I am sure no one is confused by that.
Anyway, over the years we have been able to redo the site so it actually makes sense.
But what the description meant to say is that, option sellers trade in a market neutral way. So you don’t need to market to go up or down. You can trade it when it doesn’t even move.
Also, option sellers have probability on their side. So we do trades that have for example a 70%, 80%, or even 90% probability of working out in our favor. These calculations are done using sophisticated statistics and mathematical formulas that won the Nobel Prize.
In addition, to be even safer, we use other risk management techniques like stop losses, and spreads which limit our losses.
And the example given was the insurance company. So just like the insurance company collects premiums so do option sellers.
In fact, the insurance company analogy is a great one.
Because as well talked about in 8, the real reason options were created were as a way to lose money. They were created as a hedge. As insurance.
So the option seller acts as the insurance company be selling options to farmers, manufactures, and investors who are looking to protect their positions.
That’s one way to describe the option seller.
The second is as a casino or more accurately as the house.
The house takes bets from gamblers and has the odds in its favor. Over the long run, the house always wins.
For us, the gamblers are called speculators. These are the option buyers who are betting against the odds hoping for a big payday. Kinda like lottery ticket buyers. The option seller is the house, and takes the other side of the bet. Once in a while, the option seller loses, but over time, the house always wins. It’s just math.
And with the odds in my favor, I don’t care which way the market goes.
I don’t have to predict. If I want to do a bullish trade, I can, but I don’t have to be right to make money.
This removes so much of the stress.
When you have a 70, 80, even 90% chance of winning on a trade, you don’t have to be the best trader in the world to make money.
You see, when you buy a stock it has to go up for you to make money.
And if it does not, then your money is just sitting there not earning anything. Unless it’s a dividend stock and you get some measly return like 2%.
And if it goes down then you lose.
You have to be right about the direction.
It is the same with buying options, except it is exponentially harder
Not only do you have to be right about the direction, but you have to know by when the move will take place, and how much the stock will move. If you are wrong on any of those three elements, you lose.
Here’s the magic:
When selling options, you get to play a range. The stock does what it does and as long as it stays in the range you want, you win.
Let’s use golf as an example.
To make money with stocks you have to get the ball into the hole in 3 strokes.
To make money by buying options you have to hit a hole in one.
To make money by selling options you just have to hit the ball onto the course.
One additional point I want to make is that emotionally, winning more often does wonders for your self-esteem and confidence. And as a trader, having confidence in your trades and yourself is a key factor to success.
Because will selling options, what we are doing is hitting base hits. Over nd over. Not trying to hit homeruns. Because eyou know what happens to the guy who tries for homeruns – he strikes out most of the time. Andin investing, a strike out means losing money which is not a good thing.
So let’s do a couple examples.
Now there are so many strategies that you can use to sell options, but lets stick to some of the more popular.
Let’s say you find a stock that is moving higher. It is trading at $100 and for the past 3 months it has moved higher a few dollars a month.
What we can do is sell a put spread on the stock.
So we can do a trade that gives us say an 80% probability of profit. The trade will last 30 days. And can pay us a potential of 10%.
Since we are selling a put spread that means that we want to stock to move higher and stay above the strike price of our sold put.
For example, if we sell the 90/85 put spread, that means we want the stock to stay above $90 a share for 30 days.
Now this is a stable company that has been moving higher so the chances of the stock dropping 10% in 30 days is pretty low, only 20%.
But, there still is a chance right? And we want to protect ourself too. So that is why we did a spread – which is two puts. You sell one put to collect the premium, you buy another put to protect yourself and limit your loss.
So in this case, we did the 90/85 strike put so we cannot lose more than $5 per share or $500 per spread. Even if the stock goes to zero. If the stock drops below $85, the put we bought will increase in value and offset any loss.
In reality we have a limited loss.
We have a trade with an 80% probability of working in our favor.
It is only 30 days long.
We can make a potential return of 10%
We have a limited loss of $500 per spread. Which is the most we can lose.
And we have identified a stock that is in an uptrend meaning it is moving higher. We are trading with the trend, but even if the stock starts moving sideways or moves down a little, the trade will still profit as long as the stock stays above $90 a share which would be a 10% drop in price.
Sounds good right?
Now you might be thinking, yea but it is probably hard to find trades like this. No, not at all. I could find hundreds of trades like this in just a few minutes. Doesn’t mean I would do all of them because of other reasons.
But if wanted to make it strictly based on math, then yes you could find thousands of trades like this instantly.
Now I like to use my own noggin a little too and only trade on certain stocks, that have been behaving properly lately, and I avoid trading certain times, like when there is a FED announcement or during earnings. So that only increase my chances of having a winning trade.
Let’s look at another example.
Same stock but now, it is trading at 100 and just moving sideways from month to month. It moves a couple bucks then back down but stays near 100.
What we can do here is maybe an iron condor.
We would still sell the put spread exactly like the first example. That trade would probably still work.
But you can also sell a call spread and double your money with no additional risk or capital needed.
We have the stock trading at 100.
We sell the 90/85 put spread. So we are safe for 10 points on the down side.
Then we could sell the 110/115 call spread.
This spread would win if the stock is trading below 110 at expiration.
So now we have a zone or a box around the stock. We want it to trade in-between 90 and 110.
We could make 10% for the puts, and we can make another 10% for the Calls.
So now we can make 20% in just 30 days.
But our max loss is still the same. Why? Because the trade can only lose on one side. At expiration the stock can only be up or down. Not both. Both spreads cannot lose. One has to win.
On a stock moving sideways, you can also trade other strategies like butterfly spreads, time spread, diagonals, ratios, and many more.
And we haven’t even talked about two of the most common and popular strategies, the covered call and naked put. Well leave these for another episode.
But as you can see, you have many options when selling options. Pun intended.
That’s why I like to refer to selling options as selling time.
The options have an expiration date. After that date, the trade is over, the options go away like magic- poof.
And everyday you are in the trade, you get closer and closer to expiration. And so the options lose value everyday.
You get paid for waiting.
So yes, Virginia, I do have time on my side.
And that is how you trade with the odds in your favor!
If you want more details into the trades I just described, just hop on over to optiongenius.com and sign up for our free 9 lesson course on selling time. It will give you real life examples, and go deeper into the subject.
What to Learn How To Sell Options? Get Our Free Course at – www.optiongenius.com
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Just what I have been looking for in learning about selling options.