Option writing is a strategy with a proven long term track record of success ever since options themselves have been created.
This article will provide a guide for options writing designed for beginner investors who have very little knowledge of options themselves.
Our goal is to understand the reasons why options writing makes money.
For more intermediate and advanced investors, this is a good simple review of some principles that will make option writing profitable in the long term.
Hopefully, this will serve as a guide to further your interest in options and alternative income streams for beginner investors.
Contents
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- Why Do People Buy And Sell Insurance?
- Why Should You Consider Writing Options?
- How to Structure Options Writing Trades?
- Concluding Remarks
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Why Do People Buy And Sell Insurance?
Have you ever thought that you have overpaid or are overpaying for your insurance?
News flash, you are most likely right.
Providing insurance is a money-making business, and it is not a small one.
In 2020 over 1.28 trillion dollars of insurance premiums were paid by individuals.
These people are looking to insure everything from their homes to microwaves, to even their health and hands (think a plastic surgeon).
This insurance is rarely profitable. Most premiums are paid out and never seen back.
These premiums pocket large amounts of money for insurance companies fancy offices, bonuses and Herman Miller boardroom chairs.
Of course, this money is not completely free.
Occasionally an unforeseen event happens, a forest fire destroys a home, or your nephew sticks a fork in the microwave.
Then, the insurance company has to payout.
When this happens, the amount is far greater than the average premiums they receive.
It is easy to think of insurance as a rigged game.
Let’s be clear.
Nor the insurance company or the individual buying insurance is stupid.
A rational individual buys insurance for losses they are not prepared to live with, generally things such as their home, car and health or sometimes just for peace of mind.
An insurance company provides this assurance but needs some incentives to take on the added risk.
After all, receiving a few hundred dollars a month from thousands of policyholders sounds great until a hurricane strikes, and you are on the hook for millions.
Maybe you have seen these companies and thought to yourself.
I wish I could sell insurance for myself, but I do not have the qualifications, money or resources to set up an insurance company.
The good news is you can still be an insurance provider.
It turns out any person with a few thousand dollars, a computer, and an internet connection can be an insurance provider themselves, all through writing options.
Why Should You Consider Writing Options?
An options contract is just like an insurance contract.
One investor buys insurance through a call or a put option.
This gives them the right to buy or sell a security at a certain price before certain expiry date.
The other investor sells them that insurance in return for a premium.
Just like other forms of insurance, options contracts usually are overvalued.
After all, if insurance were free for portfolios, then everyone would buy it.
The overvaluing of options contracts through time is a phenomenon known as the variance risk premia.
While it is true that variance risk premia can be negative over shorter periods of time, over the long term, it is resoundingly positive and will likely continue to be so.
Of course, there are many caveats, and not all insurance is created or priced equal after all.
These caveats create a challenge.
We can write options on thousands of equities, interest rates and commodities, so how should I know which options to write?
For an astute investor, understanding company fundamentals, volatility, and more in-depth analysis can result in resounding gains from writing options at the correct time.
This is the same as an astute insurance provider can know when a policy has added risks below the surface.
Yet, odds are you didn’t go to school as an insurance broker, nor are you a professional trader.
Can you still make money writing insurance without knowing much about the market?
Yes, and here are a few simple, intuitive steps to do so.
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Sell the Insurance People Want!
Imagine you are at an insurance fair trying to sell toilet insurance.
The odds are you are not getting a buyer.
Nobody wants insurance for their toilet.
Even worse is if you finally get someone to buy your insurance at a marked-down price, they are the ones probably getting a good deal.
Hence provide the insurance people want.
This will naturally lead to higher premiums and profit over time.
In the stock market, the options in the most demand are usually index put options which protect a portfolio against a market-wide drawdown.
As this risk is, to an extent, undiversifiable, investors are willing to pay up for the protection index puts provide.
It is a risk they do not want to take.
The data backs up this trade as index options have historically had a much higher premium than single stock options.
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Focus on Liquid Underlyings
Perhaps at the local fair, you have had the chance to see a jar of pennies (or other small objects).
Guess the right amount of pennies, and you win the jar.
It is not easy to do!
Most likely, you will be significantly off.
Interestingly, while your individual guess is often not very accurate, you get a remarkably close guess to the number of pennies in the jar by taking all of the guesses and aggregating them.
This is known as collective wisdom.
The stock market is unique in that everyone can see each other’s guesses, and the average guess is the price of the option.
This usually results in a very fair price, especially on liquid options.
While there may be certain opportunities in illiquid options, there can equally be times where you are on the wrong side as a beginner.
Add increased commissions and transaction costs, and it is not pretty.
By writing options on more liquid underlyings we reduce execution costs and skill while also ensuring we get a fair premium (fair price + variance risk premia) for our contracts.
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Do Not Sell Too Much of a Good Thing!
Remember, the first slice of pizza is always the best.
Even after the sixth slice, an avid pizza lover might want to throw up.
As an options writer, it can be tempting to sell more and more options when the experience goes well.
Despite this, overleveraging, even on a good thing, will eventually lead to disaster.
Whenever you write options, be aware of the absolute worst scenario that can happen.
If you cannot survive or live with it, trade a smaller size.
How to Structure Options Writing Trades?
There are numerous ways to structure short option trades.
For an investor who wants long exposure, simply selling S&P 500 puts will offer both long equity exposure and short volatility (insurance writing) exposure.
For investors who do not want to take a directional view, Strangles or Iron Condors are two good choices.
These are trades where the same delta put and calls are both sold.
Generally speaking, option writing is a stress-free process.
When transactions go against you, it’s crucial to know how to hedge your position.
Concluding Remarks
Writing (or selling options) is profitable in the long run.
Even if you are a beginner, learning to write options and take advantage of these premiums is not highly complicated.
All you need to do to be profitable in the long run is sell the options that investors want and are liquid.
Despite this, it is essential to understand risk management as writing options, like insurance, has a significant tail risk.
The good news is by sizing your trades small; you can sell insurance by yourself and reap the long term gains in an investment portfolio!
Trade safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
The post Option Writing: The Ultimate Beginners Guide first appeared on Options Trading IQ.
Original source: https://optionstradingiq.com/option-writing/
