Tap Into Sky-High Option Premiums

By MoneyShow.com | August 20, 2011 AAA

The option chains show that volatility and option premiums are at levels not seen in a year, and as a result, selling options in today’s market environment is an excellent strategy.

This article explores the selling of premium that option traders should be considering due to the increase in volatility and overpriced premium.

In our option classes, we teach students to be premium sellers when the implied volatility (IV) is high. Most of the time, when we go through various examples, we find the IV to be somewhere between the extreme high or extreme low. Due to the recent crash caused by S&P’s downgrade of US debt and the temporary bounceback caused by Ben Bernanke and the Federal Reserve, the IV has peaked at levels not seen in a year.

We have selected the Spyder Trust (SPY) to show those extremes:

chart

Click to Enlarge

chart

Click to Enlarge

Having verified the IV facts on the Chicago Board Options Exchange (CBOE) Web site, we can move our examination to the option chain of the ETF that we have used for our IV scrutiny.

In the figure below, the focus should be placed only on two columns: Intrinsic Value (colored in yellow), and the Bid/Ask columns, depending on what market action we are taking. If buying is taking place, then we look at the Ask column versus Intrinsic Value. If selling action is being performed—as it should be—then we still look at Intrinsic Value, but this time, the Bid column.

chart

Click to Enlarge

For instance, in the graphic above, when looking at the September 120 call, we see that it has no intrinsic value because the Spyder Trust (SPY) closed on Thursday (August 11) at $117.37. Clearly, the 120 call is out of the money by three steps, however, the premium is quite hefty. The Bid is quoted at 3.36, while the Ask is 3.42, and this is SPY. Usually on SPY, we are accustomed to seeing only penny-wide spreads between the bid and ask prices.

NEXT: Best Strategies for Selling Option Premium

In short, option premiums are extremely overvalued, and it would make very little sense to be a buyer. Yet to be a seller is a dream come true. So which specific option strategies are optimal for this environment?

If the bias is bullish, for instance, on precious metals or on certain commodities, then cash-secured puts is the way to go. However, if the bias is bearish on the general market, short verticals (bear calls) are the best bet.

If one feels that the market or some stocks are sideways bound—which is less likely—the choice of the day for selling premium could be the iron condor (two short verticals; also known as doing a bull put simultaneously with a bear call).

See video: The Basics of Iron Condor Options

In conclusion, no matter which way, just be a net-premium seller. Buy not, but sell.

As an afterthought, some of the European countries such as Italy, Spain, France, and Belgium have introduced a ban on short selling, and there is a high chance that more bans will be coming. Yet, when one takes a closer look at the specifics of the ban introduced by those countries and applies some critical thinking, then the transparency of the intention behind this ban becomes painfully evident. Why would they make such a rigid rule in the 21st century?

Also, who has the power and influence to make the ban happen virtually overnight? Let us look first for whom the ban is introduced and whom it aims to protect.

Thus far, the ban has been introduced on the financial and banking stocks only. Gee, could it be that they care only to protect themselves? The answer is for the reader to ponder. All this talk in the media about the “free market,” and then out of thin air, a ban on short selling gets introduced overnight, and only on this chosen sector.

Regardless of my thoughts on the regulatory environment, this is a great time to be selling options.

By Josip Causic, instructor, Online Trading Academy

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