The beautiful thing about the market is that it’s two-sided. As traders, we can analyze the conditions, spot opportunities, and determine the appropriate strategies for our trades. If we perceive prices to be low, we can choose to buy, or if we think prices are high, we can decide to sell. We have the ability to take either side of a trade, but based on the characteristics of options, we believe there’s an edge in selling options, or as it’s commonly referred to as, ”selling premium.”
This is one of the core concepts of our trading philosophy at tastytrade and to explain these concepts in further detail, our visionary creative team has filmed a new series of videos for you to devour. You can check out the first segment below, which illustrates the logic behind selling premium through two main points; limiting profitability to improve probability and taking advantage of time decay.
A little more explanation around selling options premium
When selling options, the amount of money we get (our credit we receive for the option) is the most we can make on the trade. As a result, we are limiting our profitability, since we can’t make any more than the initial amount we receive, but in doing so we’re able to increase our theoretical probability of success. We can improve our chances of success by choosing to sell strikes at our desired probability of expiring out of the money.
What exactly does this mean? Well, look at it this way... Let’s say you’ve decided that you think the price of a stock is going to increase and you want to take advantage of this possible move by placing an options trade. One way to do this is to sell a put option. When you sell a put option, you receive a set amount (credit) for selling the option and you want the price of the stock to stay above the strike price of the put. Ideally, the put expires out of the money and is worthless. But what strike should you sell the put option at? Well, in the dough platform you can see the probability of each of the available strikes expiring out of the money and then choose your theoretical probability of success at the time you place the trade. These probabilities are based on the current market conditions at the time you place the trade. You may choose to sell a put close to the price of the stock that has a probability of 55%, or maybe you decide to sell a put further away that has a probability of 75%. Either way, selling options gives us the ability to select probabilities in our favor and improve our chances of making a profit.
High probability isn’t the only reason we like to sell options though. Another benefit of selling premium is that it allows us to take advantage of what’s known as time decay. Since all options have an expiration date, with each day that passes in time, the option’s value will decay and become worth less and less, should all else remain equal. When buying options the time decay works against us, but when selling options, it works in our favor, since the goal when selling is to be able to buy the option back at a lower price and make a profit.
Make sure to check out next video in this series to learn more about liquidity!
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