When’s the Right Time to Sell Options?
When’s the Right Time to Sell Options?
By positioning your short strikes out-of-the-money, you always have a buffer built into the trade
As a core portfolio, short options are more strategic than long options because short options remove the need to be directionally correct.
While selling options is generally effective all the time, they are even better in high-volatility markets because volatility has been shown to be mean-reverting over time.
Still, it can make sense to add long spreads to your portfolio when volatility is on the lower end of its range.
Generally speaking, your default setting as an options trader should be to sell options, not buy them. When you buy options, you have to be right directionally to make money. Sure, there are some situations where you can eek out a profit on a long option position without getting your directional move, but they are few and far between.
When you sell options, you don’t have to be right directionally to make money. By positioning your short strikes out-of-the-money, you always have a buffer built into the trade. The stock can just meander around and even move against you some, and you can still be profitable.
In a market that is quite random and unpredictable, that’s a good start to building a strong portfolio.
The perfect market for selling options
While selling options in general is a good trade, there are times when it can be even more advantageous—when implied volatility is elevated. Volatility has been empirically shown to possess mean-reverting qualities over time.
Therefore, when volatility is on the higher end of its range, it naturally wants to revert back to the lower end of its range. As an options seller who’s short vega, you will benefit from this volatility contraction.
Of course, none of this is a sure thing, and volatility can stay bid for an extended period of time. But if you wait until volatility has expanded before you establish a new short option position, you’re stacking the odds even more in your favor.
What about buying options?
So does that mean you should never buy options? Not necessarily.
While buying naked long options (long calls or long puts) is almost never something we would do—because of the negative theta that can eat you up over time—buying long spreads can make a good deal of sense at times.
Again, because volatility is mean-reverting, not only is there an advantage to selling volatility when it’s high but there is also an advantage to buying volatility when it’s low. So not only will a low volatility environment make option prices cheaper—and thus reduce the cost of your long option strategies—but it will also position you to benefit if volatility does indeed mean-revert and head higher.
Jim Schultz, a quantitative expert and finance Ph.D., has been trading the markets for nearly two decades. He hosts From Theory to Practice, Monday-Friday on tastylive, where he explains theoretical trading concepts and provides a practical application of those concepts to a trading portfolio. @jschultzf3
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