Topics in this lesson:

risk management: The bull put credit spread

Options trading can be an effective way to generate income, especially when employing strategies similar to those used by insurance companies. To grasp this concept fully, it is essential to understand the basics of options trading, including key terms and concepts such as call and put options, contracts, premiums, strike prices, and expiration dates.

what are options?

Options are financial contracts that provide the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price within a certain time frame. These contracts derive their value from the price of the underlying asset, such as a stock, bond, commodity, or index.

Call Option:

A call option grants the buyer the right to purchase the underlying asset at a predetermined price (strike price) before the expiration date.

Put Option:

A put option gives the buyer the right to sell the underlying asset at a predetermined price before the expiration date.

Key terms:

1. Contracts

Each options contract represents 100 shares of the underlying asset. Buyers of calls or puts pay a premium to the seller for this "right." Sellers of these contracts receive the premium as income.

2. Premium

The price paid by the buyer of an option. This premium fluctuates based on market conditions, including the volatility of the underlying asset and time until expiration.

3. Strike

The predetermined price at which the buyer can exercise the option to buy (call) or sell (put) the underlying asset.

4. Expiration Date

The date by which the buyer must exercise their option. After this date, the option becomes worthless if not exercised.

The Basics of Options Trading

Example: Buying a Call Option

Suppose an investor is bullish on Apple Inc. (AAPL), currently trading at $237 per share. The investor could buy an out-of-the-money (OOTM) call option with a strike price of $245, expiring in one month. If the premium is $2.00 per share:

Cost of trade:

$2.00 x 100 shares (1 contract) = $200

potential outcome:

If AAPL trades at $260 at expiration, the profit would be calculated as follows:

($260 - $245 - $2) x 100 = $1,300, a 650% return on the initial $200 investment.

Reasons for buying options:

Hedging

Protecting an existing position with an options contract.

Advanced Strategies

Engaging in multi-leg options strategies.

Speculation

Leveraging the contract for directional bets on price movement.

However, if the price of the underlying asset does not move favorably, the full premium paid for the option may be lost.

Selling Options: The Insurance Model

Selling options for premium is a strategy that aligns closely with the principles used by insurance companies. Like insurers, option sellers analyze risk, charge premiums, and profit from the passage of time and reduced volatility.

Why Selling Options Works

1. Time Decay:

Options lose value as time passes, especially if they are out of the money. This phenomenon, known as theta decay, benefits option sellers.

2. Implied volatility:

Most options are priced with higher implied volatility than the actual historic volatility of the asset. This creates an inherent edge for sellers.

3. high probability of expiration:

Historically, the majority of options contracts expire worthless, meaning sellers keep the entire premium.

Example: Selling a Put Option

Imagine an investor is bullish on gold and decides to sell an out-of-the-money (OOTM) put option on the SPDR Gold Shares ETF ($GLD):

Current Price: $245.50

Strike Price: $240

Premium received: $2.00 per share, or $200 per contract (100 shares).

outcomes:

If Price Remains Above $240: The option expires worthless, and the seller keeps the $200 premium.

Premium received: The seller is assigned and required to purchase 100 shares of $GLD at $240 per share, regardless of the market price.

Risk Management: The Bull Put Credit Spread

To mitigate risk, traders can employ a bull put credit spread. This involves selling a higher strike put while simultaneously buying a lower strike put to limit downside risk.

Example:

Sell a $240 put.
Buy a $235 put.

This strategy reduces the maximum potential loss while still generating premium income.

Key Considerations for Options Selling:

Asset Selection:

Focus on stable, high-quality stocks or ETFs that you wouldn’t mind owning if assigned (e.g., $SPY, $DIA, $KO).

expiration dates

Typically, selling options with one-month expirations provides an optimal balance of premium income and time decay.

delta

A delta of 20-30 is often used to select options with a low probability of expiring in the money.

Pros and Cons of Selling Options

Pros:

High win rate

Less dependence on precise market timing or direction.

Generates steady, consistent income with proper risk management.

Cons:

Requires significant capital for selling naked options.

Risk of assignment and large drawdowns during market crashes.

Inappropriate for highly volatile assets without proper hedging.

Conclusion

Selling options for premium offers a disciplined, systematic approach to generating income, akin to the operations of an insurance company. By carefully selecting assets, managing risk, and leveraging strategies like credit spreads, traders can capitalize on the natural advantages of time decay and volatility reduction.

For those looking to get started, platforms such as Webull and Interactive Brokers provide robust tools for options trading. However, this strategy requires conservative risk management and is most effective when applied to stable assets over time.

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Leveraged trading in foreign currency contracts or other off-exchange products on margin carries a high level of risk and is not suitable for everyone. You may lose more than you invest. Price and performance data is provided for informational purposes only and is not investment advice. Past performance is not indicative of future results.

There is a significant degree of risk involved in trading securities. With respect to foreign exchange trading, there is considerable risk exposure, including but not limited to, leverage, creditworthiness, limited regulatory protection and market volatility that may substantially affect the price, or liquidity of a currency or currency pair. CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. The vast majority of retail client accounts lose money when trading in CFDs. You should consider whether you can afford to take the high risk of losing your money.

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