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8 Oct

The House Always Wins. Intro To Selling Naked Options

by

Firstly, if you want to learn this you will need top level options trading clearance at your broker. Selling naked options is the riskiest thing you can do. You need to really understand what’s going on before making a trade. I highly encourage everyone to either “paper trade” their ideas before putting real money to work or at least make very small trades as you get started.

I’ll rarely sell uncovered (naked) options with individual stocks, there’s too much risk there.  How many times have you seen a relatively stable stock (think Volkswagen) suddenly experience wild moves out of nowhere?  It happens.  Maybe not often, but when it does that can be very painful as an options seller so I try to avoid that.

Instead I stick to selling options on ETFs / ETNs for the vast majority of my trading.  Those have much narrower trading ranges and are not typically going to have the wild moves that an individual stock will experience.

My favorite options trade involves VXX, so let’s use that as an example.  With VXX, we’re typically not worried about it falling 20% overnight, but many traders worry about the 20% gaps which are very, very rare.  That is a prime time for me to sell that “insurance” to the nervous buyer.  When selling options, always think of yourself as the “insurance company” or the “house”.  You are the one collecting the premium in exchange for giving protection to another party.

When you wreck your car, the insurance company collects the premium you paid them but then they need to pay out a lot for a new car.  Good deal for you bad for the insurance company, right?  Well, think of how many premium payments you’ve paid your insurance company over the years.  Maybe you’re a good driver and never collected a dime from them.  All those “low payments” you make every month are pure profit for the company.

The same applies to stocks.  Many speculators want to bet on stocks without owning them.  To do this they buy options from traders willing to sell them.  Do you think the seller would sell the insurance if it were not in their best interest over time?  Of course not!  Options are always priced in favor of the seller.  This is one of the few areas in trading that I know of where YOU can actually have an edge on every trade.

Back to our VXX example.  In this case, I want to SELL options on days when VXX is up nicely (I’ll detail my exact strategy on this in future lessons). The basic premise is this — people panic and pay big premiums to you for insurance against VXX (or any stock) going higher. Your goal is to collect 100% of those premiums, so the farther out from the current price (strike price) the better your odds of winning.  Also, the longer time period until the option expires (option expiration) the higher the price of the option will be.

These are the 2 main things I am concerned with as an options seller — the VOLATILITY of the stock and the TIME VALUE (or how much time is left on the option).  The higher these 2 factors are the higher the premium I can collect.

When I’m the seller, I am the “house” making the trade.  When you sit to play Blackjack at a casino, do you think it is better to be the HOUSE or the GAMBLER?  Over the long run, you REALLY want to be the house, right? We’ve all made a few bucks at the casino one night, right?  Everyone remembers those nights.  But how about if you were there 10 nights? No way you’d be profitable.  I’ll be the house any day!

The best way to teach this is to deconstruct a trade. Basically I’m going to serve you a fine dinner and difficult recipe, let’s say beef bourguignon, then after you eat it, I’ll share with you how I made it, step by step, ingredient by ingredient.

Today is Thursday October 8, 2015. I think the QQQ has the most potential to slide here. I don’t think QQQ is going much higher tomorrow (Friday) and I don’t want to outright short the index at this level.

Selling QQQ options overnight here seems like a good idea though so I placed a small bet. I considered selling either the 106.50 for .23 for Friday October 9, 2015 or the 107.50 for .40 for next week Friday October 16, 2015. Overnight is more of a roll of the dice versus the week long wait.

For the purposes of teaching, I did a really small trade here and went with 50 contracts on QQQ 106.50 that expire TOMORROW for $.23. Basically we want the QQQ under 106.50 at close tomorrow. We’ll pick up $1,100 if we win 100%, which I expect to be the case.

However, it could be a much bigger loss depending on how the QQQ does tomorrow. When selling options you can lose way more than 100% if you’re not careful!  So please, please be aware of this and take the trading lightly until you’re very confident in what you’re doing.

When we look at the QQQ though, even with the rally in the market today it was the laggard.  SPY and IWM were both up .80%, while QQQ was up only .35% (or $.37 on the day).

My breakeven on the trade is: 106.50 +$.23 = 106.73.  This is the price I really hope QQQ trades below tomorrow.  If it trades below 106.50 then I collect 100% of the premium I collected, and we do it again.  If it goes to 107, then it is 107 – 106.73 = .27 meaning .27 x 50 contracts = $1,350 loss. Up $2 and you’re not going to like selling options anymore! But the odds of that are really, really low. See, above 106.73 we’re basically short 5,000 shares of QQQ. Every $1 above that is -$5,000. But that would never happen, right?

So 107.73 = $5,000 loss for us, because even is 106.73.

The one day expires are pretty risky but pay out quickly. I like to sell farther out for higher premiums and wait on them. That way you collect the time premium on it. As the seller you love to sell the time to people.  Remember what I said above about time value and volatility.

Again, let me point out, this is not the ideal type of trade we’ll normally do. But because I wanted to start teaching today, this gives me a concrete example to use. That said, if it works, even a “not ideal” trade paid 100% overnight.

Now to discuss the margin. E*Trade wants 15% of the “notional value” on margin. So that is 5,000 shares x $106 for QQQ = $530,000 in value. 15% of that is roughly $75,000 in margin. This is why you don’t see a lot of small accounts doing this. For tomorrow, I am putting up $75,000 of collateral in my account for the possibility of making $1,100. But keep in mind, the options are always priced fairly for the sellers, otherwise there would not be any sellers. Remember when I said the seller is basically being the “house” when making the bet? Over the long run, the house always wins, right? Again, we’ve all made money at the casino on 1 night, but how about if you were there 10 nights? No way you’d be profitable.

We take some losses on the options selling, but always try to keep it to 100% loss. On overnight trades like the one I made on QQQ the odds are not 90% win rate for us, but still good. Our typical trade will be about 1-2 weeks to expiration and several dollars out of the money as an added buffer. Those options lose value everyday even if the stock is flat. And if it tanks, then you get 80% wins really quick and just cash them in!

How do we still win if the stock is flat? The time value is a big part of the value of the the option. The volatility is also a huge part of the price. So when the volatility is low, then options are lower. That makes selling them not as fun. You will win more often but collect less premium this way.

With high volatility, the option prices are high but also the risk. When SPY is moving $3 everyday like is has been over the last month, there’s a lot more risk to options sellers. But they get paid for it. Which brings me back to the reason tomorrow is NOT a great bet is because there isn’t hardly any TIME VALUE to the trade, it’s only 1 day.

That’s why the QQQ contracts 106.50 for next week were selling for $.90, tomorrow is only $.23.  That’s the time value you’re seeing. When things get to a resistance point we want to sell options out far away and at higher prices than it currently is.

I think of stock prices like a rubber band, when you stretch them near the limit that is the resistance. It might go a little farther but it is tough to pull it. Selling options a little farther than the resistance is typically a safe bet. And the father out you sell them the more time value you have to work in your favor.

That’s a lot to digest for now but tomorrow we’ll see how this trade plays out, then I can do a PowerPoint and video lesson. Leave questions below in the comments section.

Here’s the order entry in E*Trade Pro in the after hours Thursday evening.

qqq1

Here’s the trade in E*Trade Pro positions.

qqq

Wish me luck on this one tomorrow!  We’ll see how it goes and I will report back to you what I ended up doing with this trade.  Get ready to see many more of these soon!

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5 Comments

  1. Patricia

    I have a better understanding than I ever have before, even if I know it’s barely touching the tip of the iceberg. It’s nice to learn some basics on how they work. I like the insurance parallel. Thank you!

    Reply
    • Jason Bond

      Understanding premiums with the insurance parallel is an easy way to make sense of premiums. You’re a great driver. Super, you pay low rates but never cash them in. You’re a bad driver, no problem. We’ll just charge you an outrageous rate to make insuring you worthwhile. VXX is that teenage driver with a couple of wrecks on her record. She pays a lot!

      Reply
  2. gregg

    Jason, now what kind of commissions would you pay in and out of this trade? Just trying to understand the costs involved.

    Reply
    • Jason Bond

      Commissions are roughly $50-100 / per 100 contracts each way (buy / sell) so I like to let them expire as often as possible. Save the extra commission.

      Reply
  3. Shah

    Jason, what about rolling your option plays? Do you explain that in your program as well?

    Reply

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