The Nuts and Bolts of Alternative Option Trading

 

Why Sell Call Options? 

  1. If you believe that the market is going down, bearish
  2. The strength of your belief determines what strike prices you should sell
  3. Sell out-of-the-money options (higher strike prices). If you believe prices are not going up
  4. Sell at-the-money options (at current price). If you strongly believe prices are not going up (this is not a recommended strategy)

Short Call Option Profit Profile 

  1. The potential profit is limited to the premium collected
  2. Your reverse breakeven point at expiration equals strike price plus the premium collected
  3. Reverse Break Even = Strike Price + Premium Collected
  4. The maximum profit occurs if the market is below the strike price at expiration

What is at Stake?

  1. Exposes trader to unlimited risk; thus, these positions need to be watched closely
  2. Your losses increase if the market rises faster (increased volatility) than the time decay erodes the option value
  3. The market trading above the reverse breakeven is equivalent to being short the futures contract
  4. At expiration your losses increase by one point for each point market moves above the reverse breakeven point
Short Call Option Trading Example 

This trade was recommended on The Stock Index Report written by myself and published daily by DeCarley Trading on August 8th. While the recommendation was aimed at those trading the full sized S&P, an e-mini trader could have executed a similar trade with less profit potential and less inherent risk. 

The original recommendation called for traders to sell the September S&P 500 1390 call option for $4 in premium or better ($4 in premium is equivalent to $1,000) and would have been filled on the 11th of August at or near the premium requested.  In this hypothetical example, we will use a value of $4.2 simply because that is the Black and Sholes value assigned by our charting software. 

In figure 1, you can see that although the order was placed on the 8th of August, it took a substantial rally in order to get filled.  Patience such as this can lead to missing trades but will also help you to avoid premature entry and potential disaster should the market see a spike in volatility. 

Figure  1

S&P 500 Futures and Options Chart

This particular trade creates a scenario in which there is a great deal of risk, in fact unlimited risk, above the RBE of the short option.  In this case, the RBE is 1394.2 and was calculated by adding the premium collected to the strike price of the short call option.  Keep in mind that transaction costs would reduce the amount of premium collected and shift the RBE and risk closer to the market.  The amount of premium collected represents the cushion, or the amount in which the trader can be wrong in their speculation that the futures price will be below the strike price at expiration before the trade results in a loss.

The maximum profit is equivalent to the premium collected ($4.2 or $1,050) minus any commissions and fees paid and occurs if the futures price is trading below 1390 at expiration.  However, the profit zone of this trade, or where this trades money at expiration, is impressive.  This is visually displayed in Figure 2.

Assuming that this short option is held until expiration and it was possible to sell the 1390 call for $4.20 ($1,050 for a full sized contract or $210 for a mini) in premium, it would be profitable with the price of the futures market at any point below the RBE of 1394.2 before considering transaction costs.  In other words, the only way for this position to be a loser at expiration is for the futures price to be above the RBE.  

It is important to note that although the position is still profitable in between the strike price of the short call and the RBE, the amount of the profit diminishes every tick that the market is trading above the strike price.  Once the market surpasses the strike price, it is equivalent to being short a futures contract and exposes the trader to theoretically unlimited risk.

Figure 2 

S&P 500 Futures Chart

It is easy to see that a short option strategy if implemented effectively can provide traders with an edge over the alternative.  In this particular example, the futures price was over 80 full handles away from the strike price of the short call.  The distance from the market and the amount of premium collected provides the position with plenty of room for error.  After all, I am not perfect and I assume that you aren't either.

What you should also know is that without proper risk management knowledge and instinct, what looks to be a great strategy can turn into disaster.  This is due to the fact that option selling involves unlimited risk and limited profit potential.  It is imperative that short option positions are monitored closely, additionally if you aren't ready for the responsibility and risk involved you should be working with a full service broker familiar with short option trading.  Although more options than not expire worthless putting the odds in your favor with short option trading doesn't produce automatic success.  It is critical that risk on the losing trades is properly mitigated before the damage gets out of hand.  This is where an experienced broker may come in handy. 

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