In this episode, Brandon and Christine review this week in the market, and introduce option selling strategies and when they are best to use.
SPX Candlestick Chart
[03:59] – The Market
- Indices opened largely higher for the day but were beginning to slip a bit, eventually ending in negative territory.
- Today is triple witching, meaning that options, index futures, and index future options all expire on the same day, creating additional volatility.
- Despite being a triple witching week, the market has been relatively quiet with relatively low volume.
[09:43] – Week in Review
- After a gap higher at Tuesday’s open, the market has largely slid all week.
- It opened higher Friday, but is again off from its highs.
- It’s been a good week for selling options, since volatility is high but price moves have been muted.
- Brandon’s portfolio was up about 7% for the week at time of broadcast.
- He had an iron condor that closed with a 50% profit on Gilead Sciences, Inc. (NAS:GILD), which had been open for about a month.
- He closed profitable positions on XBI, HYG, XLK, and a fast turnaround on JD.
- This week’s stock pick, PennyMac Financial Services, Inc. (NYS:PFSI), is up about 8% this week.
- Despite beating earnings ($0.03 v -$0.06e), CarMax, Inc. (NYS:KMX) was down for the day. Brandon is still holding onto it though, believing it will recover.
- Lennar Corp. (NYS:LEN) beat earnings on Tuesday ($1.65 v $1.29e), and Brandon profited 5% on it when he sold out earlier this week.
- Several analysts upped their price target this week for LEN, to an average of about $71.
[24:34] – The House Always Wins
- In episode 3, we covered how buying options works.
- Whereas with buying options, you have to have three elements all in your favor (direction, distance, duration), selling options is much more flexible.
- When an option expires under its strike price (in the case of a call) or above its strike price (in the case of a put), it’s said to expire “worthless”, since it loses all value.
- The most you can lose when buying options is the premium you pay to open the contract.
- The benefit of buying options is that you can make far more profit in a short period of time.
- You can also just as easily suffer significant losses.
- The benefit of selling options is that even though your profit per trade is less, your chance of winning is far higher.
- Selling options allows you to have small, consistent gains which add up.
- You don’t have to own an option in order to sell it. It’s perhaps more accurate to call them option writers.
- There are two parties on every option contract: the buyer, and the seller (or writer).
- The buyer of a call option pays for the right to buy 100 shares of the underlying stock at the strike price by expiration. Their underlying assumption is bullish.
- The writer of that call option contract agrees to sell those 100 shares to the contract holder (buyer) at the strike price.
- They would do this because they assume the stock price will remain below the strike price by expiration.
- For the option seller, it doesn’t necessarily matter if the stock goes down: as long as it remains below the strike price, they profit.
- The directional assumption of the call writer is neutral to bearish.
- For agreeing to enter this contract with the option buyer, the seller receives the option premium up-front.
- Note that while the option buyer has the right to buy 100 shares of the stock at the strike price, the option seller is obligated to sell those shares (if the buyer exercises the contract). This is called being assigned.
- There are ways to mitigate this risk and avoid assignment, which we will discuss in future episodes.
- In the case of put options, the buyer buys the right to sell 100 shares of the stock at the strike price.
- As such, the option writer is obligated (if assigned) to buy those 100 shares.
- The directional assumption of the put buyer is bearish, as they believe the stock will drop in price.
- However, the directional assumption of the put writer is neutral to bullish, as they believe the price will remain above the strike price by expiration.
- Assignment isn’t always a bad thing. Put writers will often sell puts on a stock they want to buy at a better price than it is currently trading at.
- This gives them the opportunity to make money by collecting premium, while waiting for the stock to drop to their desired level.
- Selling options is almost always the best choice because you don’t have to know exactly what that stock is going to do in the future.
- An option buyer has to have a directional assumption, and the stock has to move in that direction enough to at least meet their breakeven point.
- However, the option seller has much more stacked in their favor: as long as the stock doesn’t cross the strike price, they will profit, even if it moves in the wrong direction.
- As such, option sellers can win much more of the time, even 70, 80, or 90% of trades.
- The downside is that while the profit for option buyers is virtually unlimited, the profit for option sellers is capped at the premium they collect up-front for selling that option.
- That’s why we compare it to a casino: the casino knows that even if the gambler wins in the short-term — potentially even winning big — in the long-term they are likely to lose.
- The casino holds an edge over the gambler, and that edge will assert itself over time.
- Just as such, the option seller holds a significant edge over the option buyer, and the more trades they execute, the more likely that edge is to assert itself.
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