Option Spreads to Sell Premium
Most options expire worthless, so lots of traders are interested in selling options. I certainly agree with that thinking. Options are a wasting asset. All things being equal, an option will lose part of its value day after day until finally, the option expires worthless. As time passes, the option seller earns premium from time decay.
The risk to the option seller is that of a large move against his short position. All options sellers are short the chosen option strike price. Adverse moves in the underlying futures also bring an increase in implied volatility, which translates to higher margin requirements.
One way for option traders to earn premium is by shorting out of the money Calls or Puts, sometimes doing both at the same time. Most of the time, this will be a profitable strategy because the majority of out of the money options expire worthless. The danger is when the underlying futures make a large move in a direction against the seller. I have seen traders lose months of small profits when a large move against their position takes place. In fact, I have seen options sellers wiped out by such moves. These kinds of losses are unnecessary and can be avoided. In Traders Notebook we show our subscribers how to trade options a more conservative way and options spreads are one of our trading tools.
By selling Put spreads, Call spreads or both, a trader ends up with a net credit in the account and the difference between the strike prices defines the maximum risk while selling naked Puts or Calls carry unlimited risk. If the short leg of a credit spread expires worthless, the trade is profitable. Another, and probably a more important advantage of options spreads compared to naked options selling is, that spreads are usually less sensitive whenever the market moves against the traders position.
The problem with options spreads is, when you try to set up a spread in illiquid markets. Sometimes options are not very liquid and it is hard to get in and out of the trade without losing too much on slippage. Because an options spread includes two legs, the slippage would double and make the trade impossible.