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Using Spreads to Sell Option Premium

July 25, 2011 by Jeff Coglianese| Tips & Strategies

This article was originally written by Jeff Coglianese on September 02, 2005.

With the majority of options expiring worthless, many traders are interested in selling options. Options are a wasting asset. With no change in any of the underlying assumptions, an option will lose part of its value everyday until the option expires worthless. Time only moves in one direction, so an option seller benefits from the effects of time decay everyday. The option seller, however, must protect against a large adverse price move, as well as an increase in implied volatility.

Please click to view the Options risk disclosure below.

Many traders start out selling premium by shorting out of the money calls or puts, sometimes both at the same time. Statistically speaking, this can be a profitable strategy for a period of time, as the majority of out of the money options will expire worthless. The problem comes when the underlying market makes a large move in one direction and months, if not years, of profitable trades are erased.

We will discuss two different types of spreads in which the trader is net short premium. The first type of spread will be a defined or limited risk spread and the second type will be a spread with unlimited risk. There are different ways to structure both types of spreads. We will offer some different ideas that the trader can build on. As a note, many traders are frightened by the term “unlimited risk”. But keep in mind, any outright futures trade has unlimited risk with a 50% chance of profitability. Many unlimited risk option spreads have far better statistical odds of profitability with the same or even lower risk.

Please click to view the Spreads risk disclosure below.

Implied Volatility & Implied Volatility Skew

Volatility is very important in option trading. Today we will refer to Implied Volatility and Implied Volatility Skew. Implied volatility is the option market’s best guess at how volatile the underlying futures contract will be during the remainder of the option life. For example, we would reasonably expect implied volatility in corn to be greater in May, ahead of the critical pollination stage, than we would in November, after the crop has been harvested. Corn price volatility is usually more volatile in the spring and summer, as weather is a large unknown. At the end of the season after the corn crop has been harvested, there is generally less uncertainty and therefore less price risk. This is typically reflected by lower implied volatility in corn options in the fall. The grain markets in general have observed seasonal tendencies in implied volatility. Also, the energy mark ets have seen a tremendous increase in implied volatility across their option markets. This has been brought about by the great uncertainty in the supply chain that started with the Iraq war and has been exaggerated by Hurricane Katrina.

We will focus on implied volatility skew (skew) while reviewing trades in this article. If we plot the implied volatility for different strike prices we come up with the skew. There are three main types of skew that markets exhibit: the supply skew, the demand skew and the smile skew.

Supply Skew

The supply skew is defined by higher implied volatility for lower strikes and lower volatility for higher strikes. Supply refers to the natural hedging activity for the major players in the market who have a supply of something they need to hedge. Stock Index and interest rate markets have supply skews. The natural hedge for stockowners is to buy puts in order to protect the value of their “supply” of stock. Stockowners often place “collars” on their positions by purchasing puts and selling calls. This natural action in the marketplace determines the structure of the skew.

Demand Skew

Demand skews have higher implied volatility at higher strikes and lower implied volatility at lower strikes. The natural hedger in demand markets is the end user. They buy calls to protect against higher prices and sell calls to of set the cost of the calls. The “collar” for a demand hedger is to buy calls and sell puts. The grain markets and energy markets are good examples of demand skews.

Smile Skew

The third type of skew is called a smile skew. The smile skew is illustrated by higher implied volatility as you move away from the at the money strike. The at the money strike would have the lowest implied volatility while the strikes moving up and down would have progressively higher implied volatility. The smile skew is generally only observed in the currency markets. The natural hedger has to hedge currency moves in either direction depending of whether they have accounts payable or receivable in the foreign currency.

Defined or Limited Risk Spreads

Call spreads, put spreads and some calendar spreads are defined risk trades. In stock options trading, calendar spreads always have a defined risk. In the futures markets, different contracts in the same underlying month have spread risk. This risk can be substantial and adds an additional dynamic to an option trade.

By selling call spreads, put spreads or both, the trader ends up with a net credit in their account. If the short leg of a credit spread expires worthless, the trade is profitable. In a short call spread example, the trader sells a December corn $2.30 call and buys a $2.40 call. The trader sells the $2.30 call for 6 7/8 cents and pays 4 5/8 cents for the $2.40 call. The net result is a 2 1/4 cents credit less fees. If the corn futures at expiration settle below $2.30, the options all expire worthless and the trader keeps the credit. The maximum risk on this trade is the difference between the strikes of 10 cents ($2.30-$2.40) less the premium collected of 2 1/4 cents or 7 3/4 cents. I can’t speak for you, but risking 7 3/4 cents to make 2 1/4 cents does not appeal to me.

Please click to view the Spreads risk disclosure below.

The corn call example was chosen to illustrate skew. The corn market has a demand skew which has higher implied volatility at higher strikes. The $2.30 call has an implied volatility of 24.31% and the $2.40 call has an implied volatility of 26.20%. Selling call spreads in a demand skew market will result in the trader selling the lower implied volatility option and buying the higher implied volatility option. Selling low and buying high is not a good idea in general, and the option business is no exception.

If we look at selling the December corn $2.10-$2.00 put spread the $2.10 put is 4 1/4 cents while the $2.00 put is 1 5/8 cents. The net result for selling the spread is a credit of 2 5/8 cents less fees. The implied volatility for the $2.10 put is 22.43 % while the $2.00 put implied volatility is 21.39%. These examples do a great job of illustrating the effect of skew on spreads. The December corn futures settled at $2.22 1/4, 7 3/4 cents away from the $2.30 call and 12 1/4 cents away from the $2.10 put. A 10-cent move in either direction is about equal statistically, yet the put spread provides a larger credit to the seller and is further away from the underlying price. The call spread is closer to the underlying price and offers a smaller credit. Selling the put spread in a demand skew market allows you to sell the higher implied volatility put option and buy the lower implied volatility option. Selling high and buying low is generally a good thing.

Unlimited Risk Spreads

The unlimited risk spreads we will briefly cover in this article are vertical ratio spreads. To sell these spreads at a credit, the trader would buy the close to the money option and sell at least twice as many further out of the money options. Using the same December corn market, we will buy 1 December $2.30 call at 6 7/8 cents and sell 2 December corn $2.40 calls at 4 5/8 cents. The net result of this trade would be a 2 3/8 cents credit. This trade has unlimited risk to the upside with effect on the trader of being short December corn futures from a price of $2.52 3/8 at expiration. At expiration, the trader will lose money, penny-for-penny, on a move above $2.52 3/8. The maximum profit for the trade would be 12 3/8 cents if we settled at $2.40. The current market price for December corn is $2.22 1/4. The illustrated trade, at expiration, will be profitable if December corn futures are anywhere between zero and $2.52 3/8. If the trader has a bearish outlook, he can be wrong by 30-cents and still have a profitable trade at expiration. This is an unlimited risk trade, and if corn futures were to settle at $3.00, the trader would have a 47 5/8 cent loser.

Please click to view the Spreads risk disclosure below.

The above examples should illustrate a few basic ideas about skew and how to apply it in your trading. If we stick with the basics of buy low and sell high, it is easy to decide which strategy best fits your objective. The demand skew works against selling call spreads, but works for selling put spreads. The opposite holds true for supply skew situations. In a smile skew market, the skew structure works against selling both call and put spreads. Depending on the trader’s objectives, he or she may enter a vertical ratio call spread and a short put spread in a demand skew market. This may offer a comfortable risk profile, and most importantly, statistically provide the best chance for profitability.

Filed Under: Tips & Strategies

About Jeff Coglianese

Jeff Coglianese is a Senior Broker with Daniels Trading in Chicago. Jeff started in the business in 1994 with LFG (Linnco Futures Group). In 1995, Mr. Coglianese went to work for the Daniels Trading Division of LFG and has been with them ever since. Daniels Trading became an Independent Introducing Broker in the fall of 2005.

Mr. Coglianese holds both a Bachelor of Science in Finance and an M.B.A. from DePaul University in Chicago.

Jeff draws on over 18 years of experience in the futures markets along with his formal training in finance to tailor hedge programs to fit the specific needs of his clientele. He can be reached toll-free at 800-811-2844 or via e-mail at jeffcog@danielstrading.com.

Risk Disclosure

WHEN INVESTING IN THE PURCHASING OF OPTIONS, YOU MAY LOSE ALL OF THE MONEY YOU INVESTED.

WHEN SELLING OPTIONS, YOU MAY LOSE MORE THAN THE FUNDS YOU INVESTED.

STRATEGIES USING COMBINATIONS OF POSITIONS, SUCH AS SPREAD AND STRADDLE POSITIONS MAY BE AS RISKY AS TAKING A SIMPLE LONG OR SHORT POSITION.

The StoneX Group Inc. group of companies provides financial services worldwide through its subsidiaries, including physical commodities, securities, exchange-traded and over-the-counter derivatives, risk management, global payments and foreign exchange products in accordance with applicable law in the jurisdictions where services are provided. References to over-the-counter (“OTC”) products or swaps are made on behalf of StoneX Markets LLC (“SXM”), a member of the National Futures Association (“NFA”) and provisionally registered with the U.S. Commodity Futures Trading Commission (“CFTC”) as a swap dealer. SXM’s products are designed only for individuals or firms who qualify under CFTC rules as an ‘Eligible Contract Participant’ (“ECP”) and who have been accepted as customers of SXM. StoneX Financial Inc. (“SFI”) is a member of FINRA/NFA/SIPC and registered with the MSRB. SFI does business as Daniels Trading/Top Third/Futures Online. SFI is registered with the U.S. Securities and Exchange Commission (“SEC”) as a Broker-Dealer and with the CFTC as a Futures Commission Merchant and Commodity Trading Adviser. References to securities trading are made on behalf of the BD Division of SFI and are intended only for an audience of institutional clients as defined by FINRA Rule 4512(c). References to exchange-traded futures and options are made on behalf of the FCM Division of SFI.

Trading swaps and over-the-counter derivatives, exchange-traded derivatives and options and securities involves substantial risk and is not suitable for all investors. The information herein is not a recommendation to trade nor investment research or an offer to buy or sell any derivative or security. It does not take into account your particular investment objectives, financial situation or needs and does not create a binding obligation on any of the StoneX group of companies to enter into any transaction with you. You are advised to perform an independent investigation of any transaction to determine whether any transaction is suitable for you. No part of this material may be copied, photocopied or duplicated in any form by any means or redistributed without the prior written consent of StoneX Group Inc.

© 2023 StoneX Group Inc. All Rights Reserved

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The StoneX Group Inc. group of companies provides financial services worldwide through its subsidiaries, including physical commodities, securities, exchange-traded and over-the-counter derivatives, risk management, global payments and foreign exchange products in accordance with applicable law in the jurisdictions where services are provided. References to over-the-counter (“OTC”) products or swaps are made on behalf of StoneX Markets LLC (“SXM”), a member of the National Futures Association (“NFA”) and provisionally registered with the U.S. Commodity Futures Trading Commission (“CFTC”) as a swap dealer. SXM’s products are designed only for individuals or firms who qualify under CFTC rules as an ‘Eligible Contract Participant’ (“ECP”) and who have been accepted as customers of SXM. StoneX Financial Inc. (“SFI”) is a member of FINRA/NFA/SIPC and registered with the MSRB. SFI does business as Daniels Trading/Top Third/Futures Online. SFI is registered with the U.S. Securities and Exchange Commission (“SEC”) as a Broker-Dealer and with the CFTC as a Futures Commission Merchant and Commodity Trading Adviser. References to securities trading are made on behalf of the BD Division of SFI and are intended only for an audience of institutional clients as defined by FINRA Rule 4512(c). References to exchange-traded futures and options are made on behalf of the FCM Division of SFI.

Trading swaps and over-the-counter derivatives, exchange-traded derivatives and options and securities involves substantial risk and is not suitable for all investors. The information herein is not a recommendation to trade nor investment research or an offer to buy or sell any derivative or security. It does not take into account your particular investment objectives, financial situation or needs and does not create a binding obligation on any of the StoneX group of companies to enter into any transaction with you. You are advised to perform an independent investigation of any transaction to determine whether any transaction is suitable for you. No part of this material may be copied, photocopied or duplicated in any form by any means or redistributed without the prior written consent of StoneX Group Inc.

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