While selling premium can be a profitable strategy, it also comes with certain risks
Selling premium is a popular trading strategy that involves selling options contracts to other investors. Traders and investors can generate income for their long-term portfolios using strategies like the covered call and cash-secured put.
In today's market, selling premium has become an increasingly important strategy for traders and investors alike, allowing them to take advantage of market conditions and generate returns in various market types.
What Does Selling Premium Mean?
Selling premium is attractive to investors since they can benefit from the volatility risk premium (VRP). The implied volatility (IV) of stocks is generally overstated, meaning there is a premium for options buyers. Options are commonly used to hedge portfolios similar to an insurance plan. Therefore, premium sellers effectively turn themselves into stock insurance companies.
One way that investors can profit from selling premium is by using cash-secured puts. This involves selling a put option and receiving a premium from the buyer. If the stock price remains above the strike price of the put option, the writer of the option keeps the premium as profit. Conversely, if the stock price falls below the strike price, the writer is obligated to buy the stock at the strike price, turning the trade into a stock investment.
Another way that investors can profit from selling premium is by using covered calls. In this strategy, the investor owns shares of a stock and sells call options to other investors in exchange for a premium. If the stock price remains below the strike price of the call option, the writer of the option keeps the premium as profit. If the stock price rises above the strike price, the writer is obligated to sell the stock at the strike price, allowing the investor to sell their shares at a profit while still collecting a premium.
While selling premium can be a profitable strategy, it also comes with certain risks. For example, selling options contracts that are not fully covered by cash or shares can result in potentially unlimited losses.
How Do Interest Rate Hikes Affect the Options Market?
When interest rates rise, call options increase in value while put options decrease. While interest rates may slightly affect option pricing, it doesn’t generally change the strategies utilized to sell premium.
However, it’s important to keep an eye on the risk-free rate as an options trader to take advantage of buying bonds in a margin account. Many brokers only require a 10% margin requirement or less for bonds, allowing options traders to utilize 90% of their buying power to trade options while making money at the risk-free rate. Investing your money at the risk-free rate and stacking options strategies on top is a great way to maximize your profit potential.
How Does IV Affects Option Premiums?
Implied volatility can have a significant impact on option prices and premiums. When IV is high, option prices and premiums tend to be more expensive, as investors are willing to pay more to protect themselves against potential price swings. Conversely, when IV is low, option prices and premiums tend to be lower, as investors are less concerned about potential price swings.
High IV is ideal for option selling strategies since it allows them to collect more premium due to the elevated option prices. However, high IV can always go higher, so risk management is crucial when selling options. Traders often watch the Cboe Market Volatility Index (VIX) to determine the level of volatility in the overall market.
When IV is high, investors are generally fearful in the markets, causing more people to buy options to hedge their portfolios. When people are panicking to hedge their portfolios, option prices increase, allowing option sellers to collect more premium.
What Are the Best Strategies to Sell Premium in Today’s Market?
There are several option strategies to sell premium, but some common ones include covered calls, cash-secured put, and iron condors. These strategies will outperform the buy-and-hold strategy in down and sideways markets and come with less volatility.
Cash-Secured Puts
The cash-secured put strategy is a bullish trade that involves collecting a premium from selling a put option and setting aside enough cash to buy the stock at the strike price. If the stock decreases after you sell a put, the worst case scenario is you get assigned 100 shares of the stock at the strike price.
For example, if a stock trades at $100 and you believe it will stay above $100 or increase, you can sell a $90 strike cash-secured put and collect a premium. This trade requires you to set aside $9,000 in case the contract gets exercised, and you must buy 100 shares at $90 each. If the stock stays above $100 by expiration, you will keep the premium as income.
Covered Calls
If you own 100 shares of a stock, you can sell covered calls to generate income and hedge your downside risk. The covered call strategy involves selling a call option to collect a premium and taking on the obligation to sell your 100 shares if it exceeds the strike price.
The covered call is also a great hedge since the call will generate profit when the stock price falls. For example, if you own 100 shares of a stock at $100 per share, you can sell a $120 strike covered call to collect a premium. If the stock stays below your strike price, the call will generate a profit even if the stock moves up slightly thanks to theta decay.
Iron Condors
The iron condor is a neutral options trading strategy that profits when the underlying stock trades within a small range. The iron condor is a 4-leg options strategy constructed by selling a put credit spread and a call credit spread within the same order.
The iron condor is an excellent strategy to trade if you believe stocks will trade sideways and volatility will not increase. As your options near expiration, they will lose value due to time decay allowing traders to generate profit using the iron condor in flat markets.