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
