Paying attention to the results from the survey taken earlier this week (thanks to all who voted), and supplying additional detail for TR who raised the question, today's post contains a more detailed description of a topic that should be beneficial to all but the most experienced option traders.
As always, I present an opinion based on my perspective. I'm not telling you that this is THE right answer and that any other choice is wrong. My goal is to get you thinking about the possibilities and hoping you can form an opinion as to whether my suggestions apply to you, your comfort zone and your investing objectives. If you can form your own conclusions after considering more than one alternative, then it's likely you will have made a good decision for your own trading.
Question: When selling option premium, is there an optimum time to initiate the position, based on time remaining before the options expire?
Some very smart people believe that there is such an ideal time and they recommend their beliefs to their followers. They may be correct. I must confess that I have not done any rigorous (or other) mathematical study to determine whether a specific time period works out better over the long run. My guess is that a detailed statistical study would suggest that there is a window for which the combination of: probability of earning a profit and average return on investment can be optimized. But, I suspect that that 'window' varies depending on how volatile the market has been. Lacking such studies, I'll share what I believe to be true for premium-selling strategies.
a) If you are considering buying calls or puts to profit from a market move, none of this applies to you.
b) Buying a call spread or buying a put spread does count as a premium-selling strategy. Why? Because the equivalent strategy (selling a put spread or selling a call spread) is a premium selling play.
I. Strategy choice
When selling option premium, the investor's usual outlook for the market is neutral. Sometimes rallies (naked put selling) are better than declines, and sometimes vice versa (selling call spreads). But, in general, these strategies do well when the market does not undergo a large move.
The single best way to manage risk is to avoid trading too many spreads. Consider what can go wrong, give some thought to what your plan of attack will be to manage risk (you don't have to have iron-clad rules, but you do want to be prepared).
3. Probability of achieving maximum result
Most premium sellers love to sell the position and watch it expire worthless. I'm not saying that's a bad idea, but I prefer to buy back my short position whenever it reaches a low price. Because 'low' is a relative term, there's not a lot to talk about on this topic. My belief is that when there is very little left to be earned, it's appropriate to take the money and eliminate the possibility of turning that profit into a loss.
The farther OTM the options you sell, the greater the probability they will not move into the money during the time you hold the position. But there's a trade-off. The less likely it is that you will encounter a problem with the trade, the less cash you will collect when opening the position. It's up to you to find a comfort zone that is willing to accept the risk and reward for each specific trade.
Because this post's main thrust is (supposed to be) on when to open these positions, it's important to mention the obvious: the longer you own any specific position, the greater the chances that it will move far enough to result in a loss. That's the reason for closing the big winners early, but it's also a consideration when opening the position in the first place.
4. Timing the trade
This is an appropriate time to take another survey. In an effort to provide at least as much detail as I have in the past – as requested – this post is lengthy – and I have not begun to reply to the topic question. This is all background material, and this post (when completed) could be used as a significant portion of a book chapter. Thus, there's one question to ask: