An Introduction to Volatility-Selling Strategies

Along with death and taxes, there is one other fact of life we can all count on:the time value of all options ultimately going to zero. What an alluring concept!In a business where expected profits can be thwarted by an unexpected
turn of events, this is one certainty traders can count on. Like all certainties in the financial world, there is a way to profit from this fact, but it’s not as easy as it sounds.

Alas, the potential for profit only exists when there is risk of loss.In order to profit from eroding option premiums, traders must implement option-selling strategies, also known as volatility-selling strategies. These strategies have their own set of inherent risks. Selling volatility means having negative vega—the risk of implied volatility rising. It alsomeans having negative gamma—the risk of the underlying being too volatile.

This is the nature of selling volatility. The option-selling trader does not want the underlying stock to move—that is, the trader wants the stock to be less volatile. That is the risk.Profit Potential:Profit for the volatility seller is realized in a roundabout sort of way. The reward for low volatility is achieved through time decay. These strategies have positive theta.

Just as the volatility-buying strategies covered in Chapter 4 had time working against them, volatility-selling strategies have time working in their favor. The trader is effectively paid to assume the risk of movement.Gamma-Theta Relationship There exists a trade-off between gamma and theta. Long options have positive gamma and negative theta. Short options have negative gamma and positive theta.

Positions with greater gamma, whether positive or negative,tend to have greater theta values, negative or positive. Likewise, lower absolute values for gamma tend to go hand in hand with lower absolute values for theta. The gamma-theta relationship is the most important consideration with many types of strategies. Gamma-theta is often the measurement with the greatest influence on the bottom line.

Greeks and Income Generation:With volatility-selling strategies (sometimes called income-generating strategies), greeks are often overlooked. Traders simply dismiss greeks as unimportant to this kind of trade. There is some logic behind this reasoning.Time decay provides the profit opportunity. In order to let all of time premium erode, the position must be held until expiration.

Interim changes in implied volatility are irrelevant if the position is held to term. The gamma-theta loses some significance if the position is held until expiration,too. The position has either passed the break-even point on the at-expiration diagram, or it has not. Incremental daily time decayrelated gains are not the ultimate goal. The trader is looking for all the time premium, not portions of it.So why do greeks matter to volatility sellers?

Greeks allow traders to be flexible. Consider short-term-momentum stock traders. The traders buy a stock because they believe it will rise over the next month. After one week, if unexpected bearish news is announced causing the stock to break through its support lines, the traders have a decision to make. Short-term speculative traders very often choose to cut their losses and exit the position early rather than risk a larger loss hoping for a recovery.

Volatility-selling option traders are often faced with the same dilemma.If the underlying stays in line with the traders’ forecast, there is little to worry about. But if the environment changes, the traders have to react. Knowing the greeks for a position can help traders make better decisions if they plan to close the position before expiration.Naked Call:A naked call is when a trader shorts a call without having stock or other options to cover or protect it.

Since the call is uncovered, it is one of the riskier trades a trader can make. Recall the at-expiration diagram for the naked call from Chapter 1, Exhibit 1.3: Naked TGT Call. Theoretically,there is limited reward and unlimited risk. Yet there are times when experienced traders will justify making such a trade. When a stock has been trading in a range and is expected to continue doing so, traders may wait until it is near the top of the channel, where there is resistance, and then short a call.

For example, a trader, Brendan, has been studying a chart of Johnson & Johnson (JNJ). Brendan notices that for a few months the stock has trading been in a channel between $60 and $65. As he observes Johnson & Johnson beginning to approach the resistance level of $65 again, he considers selling a call to speculate on the stock not rising above $65.Before selling the call, Brendan consults other technical analysis tools, like ADX/DMI, to confirm that there is no trend present.