ANATOMY OF AN OPTION TRADE - FUNDAMENTALS OF SELLING OPTIONS PREMIUM
Below is a step-by-step guide for long term options success when applying a defined set criteria on a consistent basis given a high number of trade occurrences. Here, I walk through the trade set-up when selling options premium in the form of cash covered puts. Implied Volatility (IV) Rank, probability and managing winning trades is detailed below. Although I recommend risk-defined trades, the below example pertains to a cash covered put option however the mechanics are the same.
Cash Covered Put Option Selling - Premium Income:
Selling put options means you agree to buy shares at an agreed upon price (strike price) by an agreed upon date (expiration) while being paid a premium.
Long-term keys to durable, successful and high-probability win rates in options trading:
Be an option seller to collect premium income while taking advantage of time decay
Set the probability of success (delta) in your favor (70%, 85%, etc.) to ensure a statistical edge
Manage winning trades by closing the trade and realizing profits early in the option lifecycle
Sell options in high IV Rank environments to extract rich premiums
Sell options on tickers that are liquid in the options market
Maximize the number of trades to allow the expected probabilities to play out
Appropriate position sizing / portfolio allocation to manage risk exposure
Sell options across tickers with ample sector diversity
Keeping an adequate amount of cash on hand (~25% - 40%)
Risk-defined trades (put spreads, call spreads and iron condors)
Consistent Portfolio Appreciation:
Selling high probability of success options with a large number of occurrences can provide consistent income and smother portfolio appreciation while mitigating risk.
Identifying High Implied Volatility (IV) Rank:
IV Rank is the current IV value compared to its previous 52-week volatility range. This is a measure of how the current value "ranks" in relation to its historic volatility range.
Tesla example: 100 ranking translates into the fact that its current value ranks higher than its historic range, indicating that investors expect a huge move in the underlying stock.
This high IV Rank gives option contracts rich value and provides option traders with opportunity since IV rank is nearly always overestimated and the stock will not be as volatile as predicted by its current IV value
As the contract lifecycle unfolds and IV reverts to its mean, the option will drop in value even if the underlying stock doesn't move higher.
Probability of Success:
Based on all historical moves and magnitude of moves the stock has made in the past, its future absolute move (positive or negative) within standard deviations are predicted
As stocks become more volatile and deviate from their historical mean, IV can spike and is used to predict the future magnitude move of the stock
High IV Rank leads to over priced or richly valued option contracts where option sellers can capitalize since implied volatility is nearly always overstated and the actual move of the underlying stock will be less volatile than predicted
One standard deviation captures 68.2% of all future stock movements while two standard deviations capture 95.4%
Identifying Strike Probability:
Tesla was trading at $257 on October 10th, 2018 and based on the stock's historic volatility and IV, its future stock moves are predicted
Setting a strike price at $150 for one month out, we can see that there's a 97% probability that Tesla will trade above this price at expiration
Option contracts need to be liquid with ample open interest and volume to yield tight bid and ask spreads.
This liquidity ensures optimal option pricing execution upon sale and purchase to open positions as well as the ability to sell and purchase options to exit positions.
Combining IV Rank and Probability:
Tesla's current IV Rank was 100, indicating richly valued and overpriced option contracts
At a strike of $150, there's a 97% probability that the contract will expire worthless at expiration
Option chain showing put option premium income at the $150 strike
Summary - Selling Premium:
Current set-up for this trade yields a high IV Rank of 100 and a high probability (97%) of expiring worthless at expiration and capturing all of the premium income
The stock traded at $257 at the time the option was sold thus allowing a downside buffer of $107 per share before risk of assignment comes into play
If the stock trades higher, sideways or down (but stays above $150) the contract will expire worthless and all the premium income will be realized at expiration
The put contract was sold for a net of $3.62 per share or $362 per contract
As the contract lifecycle unfolds, the IV decreases and reverts to its mean
This mean reversion decreases option pricing and provides the option seller with an unrealized profit and opportunity to buy-to-close for a realized gain
Within 5 days of the option lifecycle:
1) Tesla traded higher (further away from its strike price) thus making it more unlikely it would reach the strike of $150
2) The IV Rank moved lower to 77 from 100
3) The option value decreased to $1.60 from $3.65 for a spread of $2.05 or $205 on the contract
4) Buy-to-close at a net of $1.60 per share was executed for a realized gain of $2.05 per share
5) Profits were realized at 56% ($2.05/$3.65) or a realized gain of $205 total in option income!