by Don Wellenreiter

Every month nearly all options, both put and call options, expire worthless, meaning that the overwhelming majority of call and put buyers lose money.  That must mean that simply reversing that concept and selling options should be highly profitable.  But strangely, that is not often the case.

Although the option seller will be successful very often, it will take just one or two losses to wipe him out.  When you sell options your gain is limited to the amount you sold the option for, less commission and fees.  Your risk, on the other hand, is unlimited.  To do this type of trading successfully you must rid yourself of any thoughts that you know where the market is going and find a way to limit your losses.  This is the ultimate goal of option premium selling.

To accomplish this goal you must sell premium on both sides of the market and to limit risk you must buy further out options on both sides of the market for protection.  By doing this you have now created a credit spread.

Creating a credit spread keeps you out of danger if the market suddenly runs up or down.  Your total loss is limited to the difference in strike prices minus the premium received.  In other words, if you sold a September 1600 call and bought the 1610 call for protection for a total credit of 250 ticks, your maximum loss would be 1000 ticks (1610 – 1600), less the original credit (250) for a maximum loss of 750 ticks.  My objective is to have the September S&P close below 1600 by the time the option expires in September.

Remember, that the S&P 500 may either be quoted as “ticks” or points.  250 ticks is the same dollar value as 2.50 points.  If you use the tick value you times it by $2.50 to get the dollar value whereas if you use the point value you times it by $2.50.  So, 250 ticks X $2.50 = $625 and 2.50 points X $250 = $625.  It’s the same thing just different ways of saying it.

Of course you should never let a credit spread expand to its fullest loss position, so it’s not likely you would lose your entire investment.  But if, for whatever reason, you can not get out of the position, you know that you have a defined-risk position.  With a “naked” option, your loss would be unlimited.

The largest amount of capital that you should risk on any one position should not exceed 15% of your total account.  If you have a $10,000 account, for example, your maximum risk in any trade should be $1,500.  Since every point in the S&P is worth $2.50, my total loss allowance would be 600 ticks ($1,500 divided by $2.50 = 600).  Now that I know my risk tolerance, it is time to find the appropriate options to trade.

I first begin looking for options that have about 30 days or less until expiration.  Options in this time frame experience the greatest time decay, which kills option buyers but brings great joy to the sellers.  Now, I look for options that are at least 5% (for calls) to at least 8% (for puts) out-of-the-money on both the call and the put side of the market.

Once I have found them, they now have to meet my last criteria.  They must be worth 200 ticks or more if I am putting on a 10 point spread (1610/1600) or 100 ticks or more if I am doing a 5 point spread (1610/1605).  I have found, from much experience and back testing, that these parameters are the most effective for the S&P 500 on a monthly basis.  If I can not find options that meet all of the above criteria, I don’t do a trade.  The worst thing you can do is to force a trade or alter its parameters.  If it’s not there don’t trade.

I know my maximum risk on a 10 point spread will be $2,500 (1610 – 1600 = 10.00 times 2.5 = $2,500) less the premium received.  Since I have predetermined what my loss limit is (600 ticks); I can now place my stop-loss at 800 ticks (200 ticks of premium received plus my 600-tick risk tolerance).  If the spread or difference between the two options expands to 800 ticks, I will close out the position – even if I think the market will turn back in my favor.  Remember, trading requires that you assume at all times that you don’t know which way the market will go.

My maximum risk and maximum margin will be the same (I don’t use SPAN in determining my margin requirements because I believe it leads people to over trade their accounts).  If I am in a 10-point credit spread, I will assume my margin requirement is at least $2,500 (some firms will charge $2,500 plus the amount of premium you receive).  To calculate my return on margin, I would take the 200 ticks ($500) I receive from selling the spread and divide it by my maximum margin ($2,500).  This would give me, before commissions and fees, a 20% return on margin.  Not too bad!

But it gets even better!  This is only on one side of the market.  Remember, I am selling both sides of the market.  Does my margin double since I’m now putting two spreads on?  No!  The market can only go one way, so the exchange only charges margin for the closest spread.  If I can sell a credit spread on the put side for the same amount of 200 ticks ($500), I will have collected 400 ticks ($1,000) on a maximum margin requirement of $2,500, for a return on margin of 40% (before fees and commissions).

That’s 40% in one month – and limited risk!  Even after all of my years of experience with it – I still found it hard to believe!