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Everything You Need to Know About Selling Premiums

W hether you’re new to options trading or you’re already familiar with the process, you can benefit from learning about the ins and outs of selling options for premium. Selling options is a fairly easy and surprisingly profitable strategy with modest risks. By studying the process of selling option premium strategies, you can reap the many benefits and improve your portfolio.

What Is an Option?

Options are securities, or contracts, that give someone the right to buy or sell 100 shares of an asset at a specific price before or on a certain date, known as the expiration date. An option’s expiration could take place days, months, or years after you buy it. Essentially, purchasing an option gives you the chance to buy or sell an underlying stock at a set price. There are two primary types of options:

  • Put options: When you have the right to sell an options contract, it’s known as a put option. If you purchase a put option, you’re generally expecting that the underlying stock’s value will decrease, allowing you to sell it at the higher, agreed-upon price, known as the strike price. If a put option’s share price drops lower than the strike price, it is considered in-the-money. Conversely, it is considered out-of-the-money if the stock price goes higher than the strike price.
  • Call options: Having a call option means that you have the right to purchase an options contract. When you purchase a call option, you’re usually hoping that the underlying stock’s value will increase, allowing you to buy it at the lower strike price. This is when the call option is considered in-the-money. For a call option to be out-of-the-money, the share price has to drop lower than the strike price.

When you’re the one purchasing an option, you are known as a holder, while the options seller is referred to as the writer.

What Is an Option Premium?

Premium refers to an option’s total upfront price, which is determined by several factors, such as the:

  • Strike price.
  • Stock price.
  • Volatility.
  • Time value, or the amount of time left until the expiration date.

A Closer Look at the Factors That Influence an Option’s Value

A contract’s value at the time of expiration, and therefore its profitability, is dependent on:

  • Intrinsic value: Intrinsic value refers to the difference between a stock’s market price and the option’s strike price. This factor relies on the movement of the stock and determines if the option is in-the-money or out-of-the-money. When an option has intrinsic value, the premium is higher.
  • Time value: The more time an option has until its expiration, the higher its premium tends to be. Typically, options have more value when they’re further away from their expiration because there’s a higher likelihood that they will gain intrinsic value by the time the expiration date arrives. This effect on the premium’s monetary value due to the options contract’s remaining time is known as time value, sometimes referred to as extrinsic value.
  • Time decay: As an option gets closer to its expiration, its time value decreases because there’s less chance for the holder to earn a profit. Most investors wouldn’t pay a high premium for an option nearing its expiration because there’s less time for it to have intrinsic value. This declining value of the option’s premium as the expiration date approaches is referred to as time decay. The rate of the premium value’s decline actually speeds up as the expiration date gets closer.

Buying vs. Selling Options

Image via Unsplash by @jsnbrsc

A majority of the time, options end up expiring completely worthless. Because of this, it can be much more profitable to sell options rather than purchase them.

Those that write options end up keeping a majority, if not all, of the premiums most of the time, allowing them to make consistent and even predictable income. Holders, on the other hand, end up having a portfolio with quite a few losses.

When selling an option, a premium that’s higher is more beneficial. Once the trade has been initiated and the premium has been paid, the option seller usually hopes that the option will expire worthless, allowing them to walk away with the premium as their profit.

In other words, if you’re selling options, you typically don’t want the option to be redeemed or exercised, because if it isn’t, you get income from the option without having to buy or sell shares from the underlying security.

How Time Decay Is Beneficial When Selling an Option for Premium

Time decay usually works to the benefit of an option seller. Writers try to measure an option value’s rate of decline due to time decay through a measurement called theta. Put simply, theta is how much an option’s value decreases each day leading up to the expiration, and it is usually expressed as a negative number. Selling options is known as a positive theta trade, meaning as time decay speeds up, the position becomes more profitable.

Time decay eats away at an option’s value a little each and every day, even on holidays and weekends. Because of this, patient sellers benefit the most.

The buyer of an option expects a stock to move in a certain direction in the hopes that they’ll be able to profit from it. In order to profit from the trade, they have to make up for the extrinsic value that they paid for. Unfortunately, because theta is negative, they could suffer a loss regardless of whether the stock remains unmoved or moves in the right direction, just too slowly.

The Pros and Cons of Selling Options for Premium

There are several advantages and challenges when it comes to selling a premium, such as:

Pros

Some of the benefits of selling an option for a premium are:

  • It gives you steady revenue. Selling premiums gives you returns that are relatively predictable. Most strategies for selling premiums provide a high win rate, giving you a reliable way to develop your trading account.
  • The implied volatility is usually exaggerated. The volatility index, sometimes known as the stock market’s fear index, usually forecasts a dark outlook for options. Writers can take advantage of this overstated implied volatility by selling those options with higher forecasted volatility levels.
  • It has great winning percentages. Generally speaking, selling premiums allows you to win an impressive amount of trades, which is good for your portfolio and your confidence.

Cons

Though there are plenty of advantages, selling premiums has its own set of challenges, including:

  • There are no great trades. For many, the potential of a great trade around the corner is what keeps them investing in the stock market. When you sell options, you may have a more steady income, but that comes with a lower chance of getting an exceptional trade.
  • It doesn’t provide substantial returns. Unlike when you’re buying options, your maximum earning potential is the premium you collect at the beginning of the trade.
  • There’s potential for significant losses. There are times when your losses could outweigh your winning trades.

Selling Option Premium Strategies

O ne of the more popular strategies for selling options for premium is the put-selling strategy. Using this strategy, you purchase stocks when they’re undervalued and then wait until a stock is overvalued to sell the options. This allows you to charge higher premiums and earn larger returns. To determine when an option is overvalued, you can use the VIX.

When the VIX is raised, that means the implied volatility is high, and vice versa. Investors using this strategy wait until a stock’s implied volatility is high to purchase shares because it means that the stock is undervalued. Though this strategy alone could be effective, it’s beneficial to only purchase shares that you want to own. That way, regardless if you keep the premium or just end up buying the stocks at a good price, you’re happy with the outcome.

There’s no doubt that selling options premiums can be an asset to any trader’s portfolio. Even though the reward is modest, it’s reliable, and that’s rare in the world of trading. As with any kind of investing, experience and expertise are key to success. When you take the time to learn effective strategies and familiarize yourself with the market, you dramatically impact the chances that you’ll be able to consistently bring in large returns.