Selling Deep out of the Money Options to Drive Up your Odds of Success
Forget the 30 day options. The higher odds, “sleep at night” trade takes a little more time – and takes place far away from the underlying’s price action.
Deep out of the money options tend to stay out of the money, if not deep out of the money. – Investorglossary.com
Picture yourself driving a car.
If you drive down the highway at 95 miles an hour, you are going to get to your destination in a hurry. However, there are two major drawbacks: 1. There is a higher chance that you will be in an accident and 2. If you do have an accident, there is a higher chance you will get hurt.
If you drive down the highway at 40 miles an hour, you will have to wait longer to arrive at your destination. However, there is less of a chance of an accident and if you do have an accident, it will probably involve less damage to yourself or your vehicle than if you were traveling at 95 miles per hour.
The same holds true for selling options.
It is a common fallacy among option traders that in selling options, one must concentrate on options with 30 days or less remaining until expiration. The logic goes that as this is when options experience the fastest rate of time decay, why not only sell “short time” options and get the fastest time decay (and thus profits) possible?
Options are known as “wasting assets” and their value gradually decays as they approach expiration. If they expire out of the money, the option goes off the board worthless, meaning the seller keeps any premium he collected as profits. The chart above shows the rate of time decay of an option as it nears expiration. Note that the rate of decay accelerates as the option approaches expiration.
I know of some traders that do utilize this strategy and hats off to them. However, I would consider this a very aggressive, almost day trading approach to option selling. The investors I work with tend to be looking for steady, consistent growth and income, not high speed thrills. If you fall into the latter category, you may want to consider selling options with more time left on them in order to get more distant strikes. Here is why.
The value of an option is made up of three main components
- Time remaining until expiration
- How close the strike is to the price of the underlying market
You can sell an option with 3-6 months (or more) left until expiration that is deep, deep out of the money, and collect a solid premium in many of the most actively traded contracts. Now you can get that same premium for a 30 day option in that same market. The upside is that you only have to wait 30 days to expiry and, it the market behaves favorably, you will get very rapid time decay.
The trade off is, to get this premium, you will have to sell very close to the money. This means that even a small “hiccup” in the underlying market and your option could be in the money. This could happen rapidly and you could lose funds in a hurry (one reason, incidentally, that option selling gets a bad rap in some “less enlightened” circles.)
For instance, in the example below, trader John is neutral to bearish the coffee market. In September, with coffee trading near $1.33 per pound, he could sell a September Coffee 1.40 call, or he could sell a March Coffee 2.00 call. Which one looks more comfortable to you? Suppose trader John is wrong and coffee goes to $1.50? How about $1.70? If this happened, which option do you think John would rather be holding – One that is $.30 cents in the money, or one that is still $.30 cents out of the money?
Figure 1 – John Sells a September Coffee 1.40 Call
Figure 2 – John Sells a March Coffee 2.00 Call
Sure, you can buy out of either one any time you want. But would you rather be buying back an out of the money call or an in the money call? If you haven’t traded options before, you’ll want to note that in the money options tend to get expensive fast. Out of the money options, as a whole, tend to appreciate at a slower rate in the event of an adverse move.
Now, I am not proposing that you cannot lose money by selling deep out of the money options. What I am saying is that the market has to move quite a bit further to put your option in the money. Remember that as an option seller, you want your option to expire out of the money. It doesn’t matter where, as long as it is out of the money. By selling with more time, you can sell further out of the money. In my experience, this has been an advantage, especially if you are familiar with the fundamental factors driving the underlying contract’s price.
Long term, sustained moves tend to require some kind of fundamental rational. One major advantage to selling options is that it puts your position high above or far below the market in order to ride out short term swings in the underlying caused by rumors, sensational news events or short term technical breakouts. Close to the money options are more vulnerable to these types of events. Deep out of the money options are more insulated.
The ability to sell options this way is one of the advantages of selling commodities options over stock options. This advantage should be maximized to its fullest.
True, there will be some speed demons out there that will argue that shorter is still better, that long term options “give the market too much time” to move against you. In selling options on fundamentally based commodities markets, that argument seems nonsensical to me. However, to each his own.
I’ll take the slow road, even if it means waiting longer to reach my destination. I’d rather increase the chances I get where I’m going than end up in a ditch trying to get there quickly. If you are the type of investor that prefers consistency over adrenaline, going deep could be the right strategy for you.
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