For many people, long holiday weekends are a time to take a break, relax, and think about anything but work. But as option traders, we are not so lucky. Time is a critical component of option value, and when there are fewer days to trade, time decay becomes critical for both buyers and sellers. For buyers, it’s detrimental, but those who are selling option premium have an upper hand.
Memorial Day is coming up soon, and the markets will be closed for trading that day. As you might expect, the option seller has an advantage in this case because time is on their side. Selling option premium is a great trading strategy, and it’s even easier when volatility is at extremes.
The volatility indicators I follow are the VIX (SPX 500), RVX (Russell 2K) and VXN (Nasdaq). When these measures are trending, they move swiftly – and markets generally move in the opposite direction. So when the VIX surges, market players buy protection and the SPX 500 usually goes down sharply.
But volatility is low – now what?
Volatility indicators have been moving very little lately. Last week, I saw a few articles that discussed the historical significance of a low VIX reading. Implied volatility dipped under 10% last week, while realized volatility is in the 2% range. With volatility this low, it is challenging to extract enough premium to make a trade worthwhile. You may be lucky to receive a 1.35 credit on a twenty point spread going out two weeks! That is not much, but it is a symptom of low market volatility.
Even the term structure of volatility, albeit steep, only hits 16% four to five months out. Normally we might see 20%+. The current condition is defined by traders’ lack of fear, plain and simple. It is a great environment for a premium seller to trade a market going sideways.
Our strategy for selling option premium
My partner and Real Money colleague Suz Smith has created enormous value for her clients and Spread Trader subscribers by focusing on high probability, low risk trade ideas. Her tactic is to sell put spreads and call spreads so far out of the realm of hitting strikes that it would take an enormous move in the direction of her short strikes to lose money.
For put spreads, this involves selling a specific strike and covering that by buying a lower strike. For call spreads, it’s about selling a specific strike and buying a call higher. This strategy lets us define risk in case a large move gets out of hand. Note that our strategy doesn’t mean risk-free, just risk-defined.
Based on our experience and trading history, trades get “out of hand” once out of twelve trades. Even when we carefully define risk, we do encounter moments where we start to sweat. Last month, some bear call spreads blew out. Our goal with each trade is to be far enough away by expiration that time works in our favor (the option decays as it should). Roughly 80% of all options expire worthless at expiration, which we use to our advantage. We either want the options to expire worthless or close to it, which Suz has done beautifully on more than 90% of her trades in 2017 (30+ initiated).
Getting paid to play is the goal here, and with low volatility you might expect premiums to be weak. You would be correct. However, the combination of more time around holiday weekends and raising the level of the short strike can help you find the optimal strikes that will expire worthless (or close to it). Start looking for these opportunities now.
We have many other holidays coming this year when markets are closed, so use Memorial Day weekend to experiment and learn more about selling option premium. Got questions? Reach out to Suz at suz at explosiveoptions dot net.
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