Investors are scrambling to find income in today’s ultra-low yielding environment. The low interest rates as well as fewer and fewer solid stocks paying consistently high dividends have forced the savviest investors into more esoteric ways to earn income from their portfolios.
Add in the fact that it appears that the stock market has reached a short term high, at the very least, and it paints a difficult picture for traditional income seeking investors.
One of the most popular ways to ramp up income from the market is selling options. Also known as writing options, this is a proactive and highly effective method of earning a consistent income.
However, it is not without risk. In fact, selling options to earn income can be extremely risky if you don’t proceed in a reasoned manner.
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This article will provide 5 rules to help ensure your success as an option seller.
First let’s take a closer look at the macro environment.
2015 has been an interesting year for the stock market. Soaring to all time highs by an accommodative monetary policy, climbing earnings and an economy starting to gain traction, long term investors have profited handsomely during the first half of the year.
However, the improved economy is a two-edged sword for the stock market. The Federal Reserve has been forced to end the quantitative easing and begin to start a policy of interest rate increases.
When international pressures such as a floundering Chinese economy, Russian currency fears, and the specter of global terrorism are added into the equation, income will only become more difficult to find in traditional ways.
Even the stock market itself is showing signs of weakness. Shares plunged off their highs back into negative territory for the year. Next they climbed back higher but could not take out the old highs.
Financial historians will not only recognize 2015 as very interesting year for the stock market, it will also be known as a year of low yields.
In fact, income investors have become so frustrated by the lack of yield, the investing theme of 2015 could easily be summed up in four words, “The Search For Yield”
To put the low yield environment in perspective back in the early 1980’s a one-year bank CD’s paid out an astounding 10.4% and 9% yields in the stock market were commonplace after the 2008 market crash.
Talk about a radical change! Today, the average member stock of the , the S&P 500 provides just a 2.02% yield. Even the traditional high-yield sectors like international utilities are only yielding around 4%. Further cementing the dire yield situation, stocks that pay high yields often have a variety of reasons why they are extremely risky investments. You see, companies are known to ramp up their dividends to attract investors as a last ditch effort to survive. In addition, dividend yield and stock price are inversely related. This means that high yields can be the result of a plunging stock price. Sure, you will earn the yield but the falling stock price will result in overall losses despite the yield.
Despite this difficult, low yield environment, many investors are earning steady income by selling options.
However, right off the bat, before I get into the nitty gritty of earning income by selling options, it’s critical to understand that along with the consistent income comes higher risk.
This income producing method is not suited for risk shunning conservative investors but rather for those investors who understand the risk and are willing to accept it, in return for consistent income.
There is no free lunch in the stock market, or even a free snack for that matter. Every productive strategy has a corresponding risk attached. Understand and managing the risk is the key to long term success.
Selling Options: A Practical Primer
Understanding option theory and having a grasp on all the nuances of option trading is just the first step to success. You can understand option trading strategies, even the most complicated ones, but if you don’t know how to locate the right options to trade, all your knowledge is purely academic. It will allow you to pass tests, but when it comes to making real money in the stock market, this is only half the battle.
Many traders struggle with finding the right options to sell. Even the best strategies are simply not profitable without having the right stock options to apply the strategies
Here are 5 Rules For Option Selling Success
Rule 1: Only sell options on high volatility stocks
What this means is to run technical screens for stocks that are trading at a high volatility in reference to themselves. Stated exactly, you want to screen for stocks trading in the top 5% of their historic annual volatility. Most stock screening software has this feature known as IV Percentile.
The reason for this is the fact that as option premiums become relatively expensive, they are less attractive to purchase and more desirable to sell.
The other side of this equation is during times of low implied volatility many option investors use this opportunity to purchase long-dated options and look to hold them through a forecasted volatility increase.
It is important to keep in mind that although there is greater profit in selling high volatility options, the risk is also greater.
Remember, time works for the option seller. Find strike prices that are unlikely to be hit prior to expiration day. One of the best ways to do this is to check the stock for major technical resistance and support levels. Sell options with strike prices solidly above (or below) the technical resistance levels.
One can also use all-time highs, technical patterns or even the 200 day moving average as clues as to what strike price to sell.
Rule 3: Sell close to the money to maximize your profits
This definitely seems counterintuitive as the closer to the money you sell, the higher the chances that the option will go into the money. However, at the same time, the closer you move to the money, the higher the premium you collect. Remember, selling options is a trade-off of risk/reward. For those of your unfamiliar with the nomenclature, “the money” means the strike price in option lingo.
Rule 4: Sell far from expiration
This is a less risky way to collect more premium than selling close to the money. The further away expiration, the greater the time premium, therefore more money to the seller. Remember, it is time premium that is creating your profits. Therefore the greater the time premium, the higher your profits. However, it is critical to keep in mind that the longer the time frame, the more likely the trade it is to go against you. This is just another example of the risk/reward trade-off.
Rule 5: Sell the news
What this means is to take the opposite side of the move once the news is released. The old buy the rumor, sell the news is a recurring pattern in the stock market that option sellers can take advantage. There are very few patterns that consistently repeat in the stock market, the buy the rumor, sell the news is a proven one.