I have made money consistently for years writing options. I find its the best use of excess cash in a trading account, making small amounts .5% - 1% per month. Never do it on individual stocks. I personally do it using options on futures, t-notes, crude oil etc. Just take any rudimentary 60 minute trend following trading system and apply the signals to option writes. What I find, while its worthwhile doing it to supplement your account, selling premium for a living can be deadly.
Excuse my lack of knowledge on this, but if stock XYZ is trading at $100 and suddenly it goes down to $1 and then up to $5,000 and then all around, how could the price of a put option ever increase more than what could be gained between the strike of that option and the stock going to zero? A stock can't have a negative price, so regardless of whether the stock has an implied volatility of 1000, a 100 strike PUT on a stock currently trading at $100 isn't going to cost more than the maximum amount of money that could be made from that stock going to 0 -- isn't that the whole reason behind Black Scholes using a lognormal distribution for the option pricing model -- because stocks can't go to a negative amount? When all is said and done after the wild ride, my put will have a maximum value of $100 at expiration, so why would I pay more money to own it?
Because between now and expiration, that stock that went from $100 to $1 to $5000 to $100 will probably experience more massive volatility. So while the premium will eventually decay very quickly, you would pay much more than $100 in the meantime to own the put simply because the stock is so volatile.
But the entire reason why you pay for volatility for an option is because a higher volatility gives a greater chance of extreme movements -- but nothing can go below $0. The only options that would show a very high premium would be the calls, because the stock could go as high as it wanted, but the stock would never go below $0. No matter how high the volatility, it wouldn't make sense to pay for a premium that is larger than the difference between the PUT's strike and $0. Why would you pay for time premium when the stock could never get below $0? It would be like pissing money away.
For those interested I've posted our actual daily fluctuations on my site since December 1st. The futures trading is currently in a drawdown but the options have performed decently in many different market environments. The option system is merely premium shorting. www.TradingSystemDesign.com . Good trading.
I think people miss the point. Reading the posts, it starts to sound like "urban legend" stores. "I sold options naked, and boom I lost everything!!!" First, one has to have to broker's permission to sell naked options. A broker with a decent reputation won't permit it unless you can demonstrate you have adequate capitalization and experience. It is true that if you really want to do it, you will find a broker who will accomodate you, but again, if you just look at the situation it becomes clear. You need to have some basis for using this tool. Also a person wishing to sell options naked, has to understand one vitally important issue regarding "greeks" and that is that risk is not linear. If you are reading this and you don't understand what this point, don't sell naked options. Go buy McMillans book, read it and correct that deficit. In my opinion, the other issue to resolve is valuation, if you're going to take risk, you need to be compensated adequately. You need to know how to value options so that you can decide intelligently whether to buy or sell premium. Finally you need to know how to use the tools of the trade to protect yourself. I tell people who want to sell premum to start small and to sell "hedged" premium. Once you know how to protect yourself, it is a matter of acting like an adult. You decide what level of risk you are willing to be exposed to, then you decide whether you are getting paid adequately for the risk, and finally you make sure to monitor appropriately and to hedge or close the position promptly when your stops are hit. From my point of view this is like any risky pursuit, you have to have the right education, the right tools, and you need to start slowly and carefully. Regards, Steve46
We're talking about selling Puts here, giving the right for someone else to sell to u the underlying instrument for a premium. Yes at expiry there is a worse case scenario u can calculate, but the problem arrises inbetween to expiry where with a few sharp movements the MARGIN required by the exchange and/or to your broker to hold the position can be come astronomical, and I'm talking from experience. The price (or margin required for a seller)of a put CAN rise in even in a rising market and likewise for a call in a crash. If you can't work out the last sentence then you shouldn't be playing. Worth noting is that the implied volatility for a call and a put at the same strike theoritically should be the same, according to the put/call parity but very often there slightly skewed, which is a good indication of market sentiment.
You're the one who'se missing the point steve. Writing options. naked or covered, is a game for experienced players and the problem with new traders is that the "easy" money that's offered is difficult to resist when someone like you sets out such a "clear and reasonable" formula for success. And then we have the broker, the one with a "decent reputation" who is concerned for your welfare...............bullshit , all he's concerned about is covering his arse in the event that once you've lost your money you'll go crying to the regulators. Vhehn correctly points out that if you sell 10 put options at $10 then your max downside is $10,000 but even if the new trader with $10,000 does limit himself to a trade like this, how long will it be before he's doing 2 then 5 then 10. After all the guy's a trader now and he has to gear up ............I mean everybody else is doing it! We all think we're so smart but the biggest problem of all is when we do something WRONG and we get rewarded. Thats why the analogy with Russian roulette is so relevant. I'll bet that if you measured the contestants heartbeats when they did it you would find that with each successive pull of the trigger their heartbeat would slow a bit as they became "more comfortable" with the risk. Selling naked options is no different, its madness for which you are rewarded and the longer you do it the more sensible the stupidity will seem. Whatever I or anybody else say its not going to stop people writing naked options or smoking tobacco or doing other idiotic things because most of us think that the statistics only apply to other people.