A Simple Strategy for Increasing Returns in Options Trading

Selling options is an effective way to generate income from equities markets if done correctly. This especially applies to selling put options for a few reasons:

1.) Over time markets always revert to growth;

2.) Stock prices cannot below zero; i.e. the potential loss from a bad trade selling put options is limited to the strike price less the premium received;

3.) Selling puts does not require owning the stock to write covered calls, or having the capital and options trading approval to write naked calls.

The simplest put writing strategy is to write out of the money options. The premium received consists entirely of time value. However, the opportunities for realizing income are limited to the premium received. For example, if a stock is trading at $40 a share, a trader who likes the stock, or maybe only its short-term prospects may sell a put option with a strike price of $38 and collect a $0.50 per share premium, or $50 for a single contract. If the stock price stays above $38 until options expiration, then the trader pockets a $50 profit. It does not matter if the stock appreciates $10 per share during that time, the potential profit does not change.

If, however, the trader thinks that there is a good possibility that the stock price will appreciate, as opposed to merely staying above the $38 strike price, he can sell in the money put options and participate in some of the stock’s appreciation. In the example above, assume that the trader sells a put with a $45 strike price for a premium of $5.10 a share. This represents $5.00 of intrinsic value; i.e. the difference between the strike price and the current market price, and $0.10 per share of time value. Now if the price of the stock appreciates by $10.00 per share, the trader realizes $510 in profit. He also realizes increasing profits for any appreciation above the current market price, and the selling out of the money puts is the more profitable trade if the stock price appreciates more than $0.40 a share. This is because the out of the money trade was limited to a profit of $0.50 a share, and the in-the-money trade consists of the time value ($0.10) a share plus the amount by which the stock appreciated.

The potential increase in profits (920%) comes at the increased risk of losses should the stock price decrease. In either scenario, the trader’s losses begin when the stock price drops below the current market value by an amount equal to the time value; $0.5 per share in the case of the out of the money put, and $0.1 dollar per share in the case of the in the money put. In other words, the increased risk related to a decline in the stock’s price is potentially $0.40 dollars per share. Note that this is fixed for all decline that result in a loss if both options finish in the money.

This strategy was used to realize a $1200 profit on Celsius Holdings (CELH) stock after it had declined from the $70 dollar range to the $40 dollar range. When CELH was trading at about $50 a share, I sold puts with a strike price of $70. I bought back the puts when the stock price rebounded to $63 a share.