An important property of an option is that it's a wasting asset. That means, all else being equal, the option is worth less and less as time passes.
It's true that buying options can produce big gains, but the probability of making money lies with option sellers. Option sellers benefit from time decay and have several strategies from which to choose.
Risk can be measured in two ways:
- The amount that can be lost
- The probability incurring a loss
In this discussion, when I refer to 'risk,' I'm referring only to the amount of money that can be lost.
Straddle or Strangle
The method with the greatest risk is the sale of naked options - calls, puts, or both.
If you sell puts and calls, you may be selling a straddle (same
strike and expiration date) or a strangle (same
expiration date but different strikes) or two options that expire in different months.
Because the options are sold without protection, losses can be substantial. In fact, when you sell a call option, the potential loss is unlimited. Selling naked puts is not quite as risky because the stock can only fall to zero, whereas, the stock can rise indefinitely (at least theoretically).
I recommend that you never sell naked calls and only sell naked puts when you are willing to buy stock at a price below the current price.
When you sell options but make the (wise, IMHO) decision not to allow for the possibility of a major loss, you can sell put spreads, call spreads, or both.
When you 'sell a spread,' you sell one call or put option and buy another. The option you buy
- Expires in the same month as the option sold
- Trades at a lower price than the option sold, i.e., it's further out of the money
When selling spreads, the goal is for both options to expire worthless – or to repurchase the spread at a much lower price.
Selling a put spread is a bullish position.
Selling a call spread is a bearish position.
Selling both simultaneously is a market neutral position and is referred to as buying an iron condor.
The positions described above all lose money when the stock (index) makes a substantial move, and moves (or threatens to move) beyond the strike price.
There is one type of position in which premium is sold (that means the investor collects cash when initiating the trade), but the further the underlying moves, the better it is for the trader. This position is the backspread.
Beware: these positions are more difficult to manage than they appear, and although the passage of time may be your ally when the position is opened, it soon becomes the enemy.
When you own a backspread, you buy more options than you sell.
Buy 20 XYX Nov 65 calls @ $1.00
Sell 10 XYX Nov 60 calls @ $3.00
Net cash collected $1,000; or $100 per 2 x 1 spread
If the stock gets to $80, your long calls will be worth at least $15 and your short calls will be worth $20. Thus, you gain $1,400 (twice) and lose $1,700. That's a net gain of $1,100.
The further the stock rises the more you earn.
But, beware. If the stock slowly moves towards $65 (the strike price of the option you own) as expiration approaches, your short calls will be worth $5 as your shorts expire worthless. That's a very unhappy scenario for the backspreader.
I prefer selling options, but always protect my assets by buying at least one option (of the same type, i,e., buy a call when selling a call) for every option sold. I sold far too many naked calls and puts in my youth. Please don't fall into that trap.
Addendum (after market closed for the day): Amazing that I posted this on a day when the Dow Jones average declined by more than 500 points.