Warning for risks of selling put options

Read this for 5 risks of selling put options. First off, there is a guide to selling puts here. But it needs a bit of a warning label. 5 critical warnings will keep you out of trouble.

  1. Position sizing
  2. Duration
  3. Underlying Price
  4. Basic Greeks
  5. Timing
Sell put options funny
My first cartoon. Kind of sux, but I drew it on paper and photoed it.
Sorry about the quality. er…not.

Position sizing is critical

Don’t go too big – the main rule. If your account is $10k, then keep your global single trade risk below $2000. That sounds high, but we’re defining that risk as the likelihood that a stock goes to zero. That’s an extreme outlier, so your real risk, if you’ve chosen your stocks carefully, would depend on a number of factors. Historical volatility is a good one to remember.

Here is a quant take on the calculation. (Trust me, you don’t want to know how complicated it gets, and this is a ‘simple’ formula.)

Check out the downside likelihood with this calculator if the stock has options.

Duration is important

Expiry length is a dance with premium amount vs annualized return and Risk. Short expiry lengths have the lowest premium because premium is, by definition, remaining time value for the underlying to move. Mr. Market won’t pay MORE for LESS time value. He may be crazy, but he’s not stupid. Shorter expiries have lower risk when measured against time because a crash is obviously more likely the longer the time-frame extends. A crash one day after expiry does not affect an option price.

However, short expiries have greater risk in that the premium is smaller. Therefore an equivalent move to the downside is likely to cause more damage to the seller. (Hey – that’s you.) Also, short puts allow for less recovery time. As short dated options move closer to the money (because the underlying moves), sensitivity becomes very high.

Try selling same day expiries on SPY, for example. The low volatility means that OTM options will hardly move at all, even when the price makes a big move UNTIL the strike gets close to the underlying. At that point, it will take off, moving from 0.1 deltas to .4 very quickly, and as the price crosses, the delta will likely move up to .7 or higher within a $1 move past the strike. Meaning: the movements against your position are very close to full value of the underlying’s move. It’s pretty painful.

This dynamic is ameliorated the further out the expiry is pushed. Obviously, ATM options will carry a delta of .5, but with a 2 year leap you might have to go $20 through the chain to get to .4 (OTM) or .6 (ITM).

Ticker price needs to be optimized

Selling puts means finding the right target price-wise. In my experience, low-priced stocks are better, for the most parts. That’s because they can have much higher prices relative to the stock price. I’ve seen 2 year options at 30% of the stock price. That’s huge. Obviously, it’s good to do a bit of fundamentals and technical analysis checking on the stock, especially before going big.

  • Is it going bankrupt?
  • Is the price in long-term decline, or does it have an up/down pattern on a 5 year lookback?
  • Has it reversed off a recent bottom?
  • Does it pay a reliable dividend? Yes is good.
  • Does it have a decent P/E? 12-25 is in the range.
  • How does the upside chain look compared to the downside? If downside is very expensive, it may indicate a pending, very negative event.

At any rate, stocks with huge prices carry awesome premiums. AMZN can be worth $100 or so for At the Money puts as near as 6 weeks. That’s $10k if AMZN stays the same or rises in the next 6 weeks. But the risk is high. Amazon can drop $300 or so in 2 weeks, leaving you out $30,000. OUCH! The ratio of price to underlying is 4%, which is actually pretty damn great! The stock goes up most weeks, so you’d definitely make money in the long run.

To trade this, I’d use put spreads to avoid getting blown out. It’s also smart to go out to .2 deltas. However, selling ATM puts would net you the entire premium approximately 60% of the time due to the upside bias. (I HAVEN’T CHECKED THIS YET, SO IT’S JUST A GUT INSTINCT. IT CAN BE CHECKED WITH MY TOOL IN TOS.)

You’d be in profit around 70% of the time. You’d lose between 0-100% (based on premium received – so lose premium PLUS 0-100% of premium amount) 25% of the time. You’d lose 100-200% 4.7% of the time, and more than 200% 0.3% of the time. That’s according to a Standard Deviation Schedule.

note: don’t use the Yahoo option chains. It sux bad. Same with the NASDAQ chain. The headings aren’t even fixed above the data, so you see a row of numbers and have to remember what each one means. LAME as Stephen Hawking (was).

Understand basic Greeks

It’s important to understand the simple first order Greeks and their relation to the underlying’s price in order to evaluate the risks of selling put options.

  • Delta signifies how much the option price will predictably move in relation to the underlying. Delta will be very close to 0.5 At The Money, no matter what the expiry or other factors are. Delta rises as the underlying moves further towards and Into The Money, ie, as the price crosses the strike. Delta changes, of course, based on approximate measures, mainly:
  • Gamma is the rate of change of Delta, so a second order derivative. It’s less critical for this trade. Gamma trades usually involve ratios – Frontspreads and Backspreads, for example.
  • Theta tells you how much value the option theoretically loses per day, if all other things are equal – price remains the same, no announcements to make the market jittery, etc.
  • Implied Volatility measures the distance the market expects the stock to move during the time period. Different expiries have different IV’s. Here is a calculator to plug-in values and see the expected 1 standard deviation move. You’ll need price, days to expiry and Implied Volatility (should be listed with the option chain).

Understanding those is a pretty good start. Don’t get too caught up in the other secondaries and tertiaries like Lambda and Vomma – they’re for pros making trades that require massive money and huge data crunching by teams. Good to know, but non-essential are:

  • Vega is sensitivity to changes in Implied Volatility. IV is already wildly variable and the formula works in the other direction. Price changes are reflected as IV changes, not the other way. Vega is too complex to mess with, so I reccommend developing a felt sense of the relation between option price and IV.
  • Rho measures changes in value versus interest rate changes. Since interest rates are ultra-low right now and for a long time, rho is not very relevant. If rates rise, then rho might make sense to calculate in.

Timing is everything

You want to make sure you enter the trade on a pullback for several reasons:

  1. Volatility spikes during a pullback, so the option is priced relatively higher than normal. You can set your chart to show Implied Volatility. If it’s a bit higher than normal, that’s good, because you can sell the Option for a better relative price.
  2. The target option price will be higher because the underlying is closer to the money / deeper in the money.
  3. The price of the underlying will likely hit resistance and reverse at some point. Probably best to wait until you get signs of a reversal, especially for a conservative trader.

Conclusion

What are the risks of selling put options?

The main risk of selling puts is a price crash of the underlying which places the put deep in the money. But to get the best outcome, consider the 5 factors mentioned here: position sizing, duration, underlying price target, Basic greeks, and timing. Good luck.