Why can option selling be effective?

Option selling is a strategy that allows you to make money from the market not by predicting where it will go, but by predicting where it will not go. It can be a very powerful strategy if used correctly.

Let us say we have found a stock trading at $82 and we believe it will go up. When most people find this they either buy the stock, or they buy the call. This could potentially pay off big if they are right, but if the stock turns against them they stand to lose a good amount of money.

Option sellers on the other hand would find a strong uptrending stock and instead of buying a call option they would sell an out of the money put option. Lets say you sell the $75 put on this stock that is set to expire in 1 month. This would give you a premium, say $2 up front, but make you obligated to buy the stock at $75 if it reaches $75 or lower.

Probabilities

The probability that an option seller would make money on this type of a trade is realatively high. The stock could go up, sideways, or even down a little and you would still make money from the trade. You would only lose money if the stock falls below $75.

Limiting Risk

The biggest obsticle to option selling is the risk that is involved. Look at the example above, if the stock falls from $82 to $30 in that month for 1 reason or another we are in trouble. You would be forced to buy this $30 stock at $75.

In other words we are risking $75 to make $2. This makes the risk reward on the trade terrible, but there are things we can do to go around it.

Combining selling Puts with Fundamentally strong stocks is one way. If you only sell puts on stocks that you would like to own you have nothing no worry about. The worst thing that would happen to you is that you end up getting paid to get into a stock that you were going to get into anyway.

Credit Spreads

The other way to limit your risk is by utilizing the credit spread strategy. Instead of simply selling the $75 put for $2, you can also decide to buy the $70 put for $1. This lowers your possible gain, but also lowers your risk.

Instead of risking $75 then you are only risking $5 minus the $1 premium you made. A lowered risk is definitely worth the lower reward if you are not going to want to buy this stock and hold onto it for the long term.

Learning

Learning to sell options can be a tricky thing, but it can also be a worthwhile thing as well.