Selling options means that you have limited profit. After all, the maximum amount of profit you make it based on the the premium you have collected.
For example, if I were to sell a put option on META @ 90 and collected $80 of option premium - my maximum profit I will ever make on this option is $80 and nothing more.
If that's the case, why do we still sell options since we have a limited profit on it?
Well, the answer is because of the high probability of success.
Risk Reward Ratio & Probability of Winning
When it comes to trading stocks, many people talk about risk reward ratio.
"You want to be risking $1 to make $2".
From a stock trading perspective, this makes total sense so that as we trade a huge number of occurrence, the outcome is favorable as the statistics favor us.
To illustrate this, you can use the Trade Return Calculator by Coghlan Capital. By inputting this:
- Capital Size
- Typical Risk (%)
- Risk : Reward
- Win Rate (%)
When you click on the "Calculate" button, it will simulate 100 random trades based on the given parameters and provide you the results. In this simulation, it was a 270%.
While it sounds really good - based on experience, a 50% win loss with a 1:2 risk reward is actually very hard to achieve - especially if the trader get a straight streak of losses.
So Why Sell Options?
Well, with options - you actually get to choose your win rate.
(Yes, you read it right).
When we sell options, there's a factor called probability Out-of-the-money. This is the probability that the option will be out of the money, meaning the option has no intrinsic value, only extrinsic value. This simply means what is the probability you will get to keep the entire premium at the end of expiry.
In fact, you can get this data easily from ThinkorSwim platform. See below for example that a strike price of 90 has a Probability OTM of 88.67% - which means that if I sell this put option, I have a 88.67% chance of keeping the premium of $82 at the end of expiry.
What is the Risk Reward Ratio?
With a high win rate, the risk reward ratio has to be adjusted accordingly.
For myself, I typically take profit when I collected 50% premium - this means I will close the option trade once I collected $41 per option contract. I will put my stop loss at 200% of the option premium collected, which is $164. Putting these two together, my risk reward ratio is 0.25.
While these risk reward ratio may be low, the high probability of success provides me the mental fortitude to follow strategy. It is unlikely that I will get a string of losses and end up getting emotionally affected in any way.
Because of the high probability of success, it also gives me the confidence to risk more per trade - up to 5%.
Some of you may wonder why I close my trades at 50%. The reason for that is because, by closing my options earlier, I am able to push up the probability of winning up till 90+% - which gives me very consistent results.
The Bottom Line
This is the reason why I am selling options, especially in times where the volatility is very high. When the volatility gets lower and markets start to recover, I will then switch back into buying call options and continue to compound my portfolio.
If you like to find out more about selling options for cash flow, I invite you to register your interest in my upcoming Options Cash Flow course.