OPTIONS
Conservative Option Writing? Just Call It...
The Cash Cow
by Carley Garner with Paul Brittain
Here's a look at a side of short option trading that you cannot ignore.On the surface, selling options for the sole purpose of premium collection appears irrational. After all, the strategy involves unlimited risk and limited reward. However, a closer look into the reality of the options market reveals a side of short option trading that even cynics cannot ignore.
EVER THOUGHT OF TRADING NAKED?
Industry veteran Paul Brittain of the Commodity Trading School and Alaron Trading is convinced that short option trading is an effective futures trading strategy despite the negative hype surrounding it. Consequently, he is committed to educating traders about the realities of "trading naked," and is eager to share some of his secrets.
Option writing is the act of selling an option in order to collect a premium in exchange for assuming the risk of the market dropping below the strike price in case of a put, or climbing above the strike in case of a call. This is also referred to as "naked" option trading because the strategy involves theoretic unlimited losses.
The logic behind option selling is similar to that used by insurance companies. Insurers collect premiums on policies with the expectation of future payouts. By knowing the probability of a claim, they can calculate their expected return for assuming the risk of the policyholder. They are confident that they will profit over time, despite their obligation to pay claims. Casinos successfully operate on a similar premise. They bring in gaming revenue knowing that there are jackpots to be paid, but they also know that the odds are ultimately in favor of the house.
Option traders can benefit from the same premise by selling options. Proponents of this philosophy believe that it enables them to benefit from the probabilities as opposed to entering a position hoping to profit on a long shot.
Options are decaying assets; their value diminishes with every passing minute. Therefore, when buying options, time value is a powerful force that works against the probability of success. In addition, markets spend most of their time in a trading range. Thus, it should be obvious that selling options provides traders with an advantage over buyers.
For example, a seller of a call option can profit in a declining market environment as well as a market that is trading sideways. In fact, it is possible for a call seller to also profit during times of increasing prices, given that the market does so at a slow-enough pace. Even if a trader is wrong in their speculation of the direction of the market, under the right circumstances the trade may still be profitable. A buyer can only profit on a call option if a market rallies over a specific price in a specific time limit. ...Continued in the August issue of Technical Analysis of STOCKS & COMMODITIES
Excerpted from an article originally published in the August 2005 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2005, Technical Analysis, Inc.
Return to August 2005 Contents