The Top 3 Stock Option Strategies and How to Ensure that Almost Every Trade is a Winner
Approximate Reading Time: 8 Minutes
- Selling (not buying) stock market options is your best strategy
- Specifically, selling naked puts & vertical credit spreads are the trade types that I prefer
- Selling straddles seems to work well, but it is more stressful, so I don’t use this strategy
- To ensure that almost every trade is a winner, you may have to “roll out” your tested trades for a credit
Selling options is your best way to increase your income because the majority of options expire worthless.
I highly recommend selling only puts because the stock market has a “long bias”, meaning that it goes up more than it goes down; and while people are oftentimes scared of “black swan” events and market crashes, the reality is that you can protect yourself against a stock market collapse by trading small and also selling puts with a strike price that’s ~10% below the current price of the underlying.
When selling puts, I prefer two strategies:
- Naked puts
- Vertical credit spreads
Naked puts: Let’s say that Facebook is currently trading at $170. We can sell a contract with a strike price of $160 that expires 6 weeks in the future. In exchange for assuming the risk of buying Facebook at $160, we receive a credit (“option premium” or “premium”) of $2 / share. Remember that 1 contract equals 100 shares, so for every contract we sell, we’ll receive $200 (1 contract x $2 credit / share).
If Facebook trades above $160 at the time of expiration, our option expires worthless and we keep the entire $200.
In this trade, our break even point is $158 (excluding commissions), so as long as Facebook stays above $158 then this trade will be profitable.
I like selling naked puts because it’s simple, has low commissions and it offers a lot of flexibility when rolling the contract (more on this later).
The downside to selling naked puts is that it uses up a lot of buying power, which means that you cannot trade as many naked options.
However, I actually think this is beneficial because it protects you from trading too many contracts and therefore protects you from large losses during a market correction.
Vertical credit spreads: Let’s say that Facebook is currently trading at $170. We can sell a contract with a strike price of $160 that expires 6 weeks in the future. In exchange for assuming the risk of buying Facebook at $160, we receive a credit of $2 / share. At the same time, we also buy a contract with a strike price of $150 that expires 6 weeks in the future. In exchange, we pay $1 / share. So, we have sold a $160 put, bought a $150 put and receive ~$1 / share net credit (receive $2 for selling the put and paid $1 for buying the put).
There are two advantages of selling a vertical credit spread:
- It’s a defined risk trade, meaning you have a clearly defined maximum loss
- The buying power reduction is much less
In the example above, the maximum loss is $10 per share less the $1 credit, so for every contract you sell, your maximum loss is $900 and your maximum gain is $100. If, at the end of six weeks, Facebook is trading above $160, you will make $100 / contract. If Facebook trades between $150 – $160, you’ll be forced to purchase Facebook stock at $160 / share. If Facebook trades below $150, you’ll still be forced to purchase Facebook stock at $160 / share, but you can also sell Facebook at $150 / share, so you will lose ~$900 / contract ($10 per share less the $1 per share in premium).
Don’t worry if this doesn’t make sense at this moment. It’s not rocket science and once you’re exposed to vertical credit spreads with greater frequency, you’ll naturally begin to understand it.
By selling naked puts, your maximum loss would occur if Facebook went bankrupt and fell to $0. As a result, you’d have substantially greater potential risk by selling naked puts. Theoretically, you could lose $158 / share (forced to buy Facebook at $160 less the $2 / share of premium received) since 1 contract = 100 shares, for every contract sold, you could lose: $158 x 100 shares = $15,800.
Since you can lose $15,800 for every naked contract of FB vs. $900 for every vertical credit spread contract, your online broker will limit the number of naked puts that you can sell to adjust for the maximum loss differences.
So why would I personally prefer to risk $15,800 to gain $200 instead of $900 to gain $100?
There are numerous reasons. The first is that by trading a naked put I receive twice as much premium ($200 / contract when selling a naked put vs. $100 / contract when selling a vertical credit spread).
Remember, we only get paid by selling premium! And, for many of my students, they are tempted to sell 2x as many vertical contracts to compensate for the premium they pay by buying the lower priced put.
This is a mistake. By increasing the number of contracts they hold, they are increasing their risk and commissions / trading expenses.
Additionally, selling vertical credit spreads affords much less flexibility. Let’s say that Facebook falls close to my strike price, with a naked put, I can easily “roll” that position by buying back the original $160 put and selling a $158 put with an expiration date of 2-3 weeks farther out.
This can usually be done for a credit (meaning that I’ll receive money even though I have also reduced the price that I’ll be forced to buy Facebook from $160 to $158).
With the vertical credit spread, if Facebook falls, I’ll have to buy back the original $160 put, sell the original $150 put and then roll out both legs 2-3 weeks.
This is much harder and more expensive to do because the $150 put that I’d selling is practically worthless yet I have to spend more money to roll that put into the future.
Also, because my original credit was less ($100 / contract for the credit spread), my break even point is also higher for the vertical credit spread ($159 vs $158 for the naked put).
My commissions when rolling a vertical credit spread will be approximately 2x more and the credit I’ll receive when rolling out the position will also be less since I’m buying an option when deploying a vertical credit spread.
I also have been burned a few times with vertical credit spreads. I once lost ~$1,000,000 in 2 days because I traded way too large. I traded 5,000 contracts (or 500,000 shares of stock) and the market temporarily plummeted. My broker called me for a margin call and forcibly closed out my positions for a large loss. Had I traded naked options instead, I would have only been able to trade ~500 contracts, and then I simply could have rolled the contracts forward.
Instead of losing ~$1,000,000, I actually would have made money.
I do prefer using vertical credit spreads when dealing with expensive stocks such as Amazon and Google since these stocks trade for $1,000+ / share and selling a naked put requires too much buying power.
So let’s assume that we’ll mostly sell naked puts, a logical question (using the Facebook example above) is: why would would anyone risk $15,800 to gain $200? And the answer is…the odds are strongly in your favor. If Facebook is currently trading at $170 / share, the chances are ~50% that it will be trading above or below $170 in 6 weeks. Additionally, even if it’s trading below $170, as long as it stays above $160, I get to keep the $200 / contract.
Even though we have $10 / share of “cushion” by selling the $160 put (current price of $170 – $160 strike price), it’s possible that the market will correct in the future which can drop the price of Facebook below $160. If that occurs, it’s easy to simply roll the trade forward for a credit.
As a rule of thumb in stock market, if your position gets tests, you should roll out for a credit and extend duration.
Facebook is one of the biggest companies in the world. If it happens to trade below $160, it’s likely that as long as I roll out the position (and receive money every time I do so), then eventually Facebook will rally above $160 so that the position expires worthless.
While we try to never take ownership of stock – I never want to own actual Facebook stock and would prefer to roll the position until it expires worthless – I recommend only selling puts on positions that you wouldn’t mind owning.
For example, if it wouldn’t bother me to own 1,000 shares of Facebook at $160 / share, then I would sell 10 put contracts of FB with a strike of $160 (as long as the premium received is high enough).
In general, only about 5%-10% of my trades will ever get tested; so 90%-95% of them will expire worthless. Of the 5%-10% that get tested, I normally only have to roll out the position by a few weeks or months until it shows me a profit.
And that’s why everyone should risk $15,800 to gain $200: the probability of profit is extremely high and, even in the worst case scenario, you can roll out the position to continuously increase the gains while also reducing the maximum loss.
Last thing (and feel free to skip this part because it’s more advanced and I’ll write more about it in other posts), selling at-the-money (“ATM”) straddles and closing out the trade at 25% of maximum profit has a very high success rate.
This is the third best way to make money with stock options (selling ATM straddles).
For example, let’s say that Facebook is currently trading at $170. I could sell an ATM straddle (selling a put and a call with a strike price of $170 that expires in 6 weeks) and receive $8.50 / share!
If I sell 10 contracts, that means I’ll immediately receive $8,500 in premium – that’s a lot of money!
The reason I don’t like selling straddles is because I usually only trade 5-10 underlying stocks (FB, LMT, AMZN, etc.) and I believe that, long-term, all of these stocks will increase in price.
And by selling a straddle, I also have to sell a call (which means that I’m betting that the stock will FALL in price).
My concern with ATM straddles is that if FB is currently trading at $170, I believe there is a good chance it will trade above $178.50 in 6 weeks (current price of $170 plus $8.50 in option premium received) – which means that once it crosses $178.50, the trade will show me a loss.
However, research has shown that to maximize profits, I would close the trade once I have a 25% profit (so I would place the trade, then automatically place a limit order to close out the position once the option premium decreased to ~$6.38.)
As time passes, the option will decrease in value. If I place the trade, and then wait 10 days, and FB is still trading at $170, then the contracts I sold for $8.50 may only be trading for around $6.38 because there is less time until those contracts expire.
My problem with straddles is that it requires more maintenance and babysitting.
If I sell the $160 naked put on FB, I can log into my account once a day for a few minutes. But, if I sell the ATM straddle, then I’m going to be much more anxious if FB begins trading significantly above or below $170. Yes, I realize that profiting from straddles, and closing out at 25% of maximum profit, is a high probability trade, but when factoring in the increased closing trade commissions and the stress of monitoring the position, I prefer to stick with naked options and vertical credit spreads.
Stock Market Options Trading Strategies Conclusion
Sell put options, preferably naked puts. But if the stock market price of the underlying security is too high, such as AMZN, then use vertical credit spreads.
Avoid the temptation to trade too many contracts when deploying vertical credit spreads. Learn from my mistake, I lost $1,000,000 in 2 days because I traded too large – had I used naked puts instead, I would have made money on the trade instead.
If any of your positions get tested, you should roll out for a credit and extend duration.
Selling ATM straddles, and managing the position at 25%, has enormous profit potential, but I don’t do it because of the higher commissions and increased anxiety / time required to monitor the position.
Update for April 2018: Due to two-sided market action in 2018, I have begun selling strangles. A strangle is a put and a call.
In 2017, this wasn’t advisable because the calls would usually get tested. But with the market being highly volatile in 2018, it makes sense for us to take advantage of both sides (the put and the call side) and to collect as much premium as possible.
Also, selling both a put and a call doesn’t use up any more buying power than selling just one side.
For example, if FB is currently trading around $170, I would sell the $155 put and the $185 call. This is called a strangle.
This is an efficient usage of capital and doesn’t use up any additional buying power because Facebook cannot be above $185 (to challenge the call side) and below $155 (to challenge the put side) at the same time.
As a result, in 2018, I’ve done extremely well by selling strangles.