This article is based on my experience from over 45 years of perfecting my stock-trading strategies and risk-control skills.
The Idea of Income From Time Decay
I will give you the background on the method used by professional traders that puts the odds in your favor. The idea is to sell option premium when it's high and let time decay leave you with the profit for income.
I use this method, and I'll explain the details so you'll know how to do it too. I'll also describe doing this with S&P futures for an extra benefit.
Let’s Begin With a Necessary Prerequisite
This article will be most understandable if you already know what put and call options are and understand the difference between trading long and short. So I'll give a quick review.
When you sell options short on stocks or futures, the odds are in your favor. That’s because options lose value as they reach expiration due to time decay.
When you sell short1, you can repurchase the options at a lower price and keep the difference as a profit or let them expire and keep 100% of the funds received, less the commission.
Some people think you can only buy options (i.e., going long). Those traders lose most of the time. When you buy an option, you need to be correct with your assumption of the direction with the underlying instrument.
When you sell short, time decay is your friend. So even if you’re wrong, you can still profit if the stock or future doesn’t move too far in the wrong direction.
Now that we got through that preliminary stuff let's go over the steps for successfully trading options on futures.2
Sell Premium on Futures When Volatility Is High
Selling options is known as selling premium, but you want it to be as inflated as possible to quickly increase the chances of eroding in value. That's why we call it Time Decay.
To know that you are getting a decent premium, watch the volatility. It’s the best indicator. Every commodity has a different volatility index.
For example, I sell premium on the E-mini S&P Futures options. I keep an eye on the VIX. That’s the implied volatility of the S&P 500 index options.
The Chicago Board Options Exchange (CBOE) calculates the VIX continuously while the futures are trading.
When the VIX is historically low, I wouldn’t think of selling short. However, I check the VIX when I see the S&P suddenly shot up or down. If it also moved up, I might consider selling a put or a call option, depending on which way the market moved.
When you expect the market (or commodity) to go up, sell a put. That means you’re long the market. A put option will lose value when the market goes up. It will also lose value if the market doesn’t move at all. That's due to the incredible time decay again.
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Reversely, if you expect the market to drop, sell a call. That means you’re short the market. A call option will lose value when the market goes down or stays the same.
Define Your Risk to Limit Losses
When you buy a stock, you risk all the money you invested. With options, you have more control over your risk, as long as you include the following method with all your trades. (This works for stock options as well as options on futures).
I'll explain it with an insurance analogy. You sell short and buy insurance to lock yourself into a max loss. The insurance is actually an out-of-the-money option that you buy really cheap.
Here’s a simple example to show how this works:
Remember, when you sell short, you collect the premium for that sale. That is also known as selling naked, and you would not be protected if things go wrong. So you need to limit your losses by defining a risk limit, as I'll explain.
If the short option loses value, which is what you want, you can repurchase it at the lower price and keep the difference as your profit. In some cases, you may just let it expire worthless. In that case, you keep everything (less commission) from the initial sale.
However, if the underlying future commodity does not go the way you thought it would, the option can grow in value. If that happens, you can lose on that trade because you would have to repurchase it at a higher price.
The difference is a loss in that case. Time decay may help a little, but only if it doesn’t move to extremes. If things really get bad, that option can grow in value tremendously, and you could lose money because the premium would increase faster than it decays. Remember that you want the value of short options to decrease.
How to Define Your Risk
This is where defining your risk becomes beneficial. If you buy another option way out of the money at the same time you sell short, you lock yourself into a fixed max loss.
I’ll describe one of my trades as an example, so you’ll understand how this works.
An Example of One of My Trades
Say the S&P is trading at 3100, and you think it won’t go below 3000 in the next 30 days.
You sell a put option to expire in 30 days at a strike of 3000 and receive a premium of $8. Each E-mini S&P option is for 1 S&P contract, and each contract has a $50 multiplier, so you receive $400. (The multiplier defines the actual value of each futures contract, known as the notional value).
At the same time, you buy a put option at a strike of 2900, and you pay $2.90 (option price) multiplied by the $50 S&P multiplier, which is $145.
Therefore, you receive $400 less $145, or $255 for the trade. Sure, you get less than the full $400, but that long option locks you into a defined risk of $5,000.
How did I arrive at that risk figure? You sold an option at a strike of 3000 and bought one at a strike of 2900. That’s a 100-point difference, also known as the spread. Multiply that by $50 (the S&P multiplier). 100 x 50 = $5,000.
Actually, your real risk is even lower. It is $4,745. That’s because you received $255 for the trade ($5,000 – $255 = $4,745).
|Strike Price||Option Premium|
Sell E-mini S&P PUT
Buy E-mini S&P PUT
How Defined Risk Protects You
If you didn’t buy that long option and the market kept going the wrong way, you could lose endlessly, up to infinity. Of course, your broker would give you a margin call and pull you out before that happens, but at a tremendous loss, nevertheless.
When you define your risk, you’ll never get a margin call. No matter how bad things get, you can’t lose more than the amount you defined as your risk, or $5,000 in this example.
You can make that risk larger or smaller, depending on your risk tolerance, simply by making the spread larger or smaller.
If you’re wondering what the percentage gain is when the option expires worthless, divide the amount you received ($255) by the risk ($5,000). That’s a 5% profit in 30 days. Keep repeating that, and you’re making 60% per year on a $5,000 investment. However, I don’t recommend being greedy.
Why You Should Take Profits Early
You need to keep a close eye on things. If you let it go too far in the wrong direction, you would have to repurchase the options at a higher price or take delivery on the futures commodity. Of course, you wouldn’t want to do either of those.
For that reason, it's worthwhile taking profits early when you have it. The general rule of taking profits on decaying options is to close the trade when you have a 50% gain. If you hope for a home run, things can turn against you if the market changes.
On the other hand, if things go badly right from the start, get out as soon as the trade reaches the maximum you are willing to lose. As long as you learn to get out quickly when you’re wrong, this type of activity can be quite fruitful.
Greed is our enemy. Many people hope to keep all the money by waiting and letting the trade expire worthless because options tend to lose value over time due to time decay.
They think they are saving the commission since they don’t have to buy it back. However, this strategy is impractical for two reasons:
- Markets and commodities can turn around any time and move quickly in the wrong direction. Therefore, it works best to take profits when you have a 50% gain on the options trade. There is no need to wait for expiration.
You can lose a profit gain you had if the market turns on you. Of course, you can always roll down. But rolling takes extra resources, and you might just be priced out of the market if you need to keep rolling month after month.
That’s why you should close the trade when you have a 50% gain.
- The second reason why waiting for expiration is impractical is that you are tying up your money for the entire time of the trade. So if you already have a 50% profit within a month, take it.
That will also free up your resources so you can enter a new trade when the opportunity presents itself. You might find yourself repeating several trades in a month to make much more without using extra resources. Isn’t that better than waiting for that single trade to expire?
There you have it. Remember to use your due diligence when you enter a trade. Never be greedy and take your profits early. That’s the best strategy.
Advantages and Disadvantages of Futures Contracts
I Like to sell option premium with futures because of all its advantages. In addition, the disadvantages are similar to those with stocks anyway. Let's review both extremes.
- Gains on futures have a tax advantage. IRS Section 1256 allows you to report 60% of the profits as Long Term. That is true no matter how briefly you hold the trade. It’s similar for futures as well as the options on futures. With stocks, you need to hold the shares over a year for that tax advantage.
- You can buy or sell futures contracts as easily as trading stocks.
- You have leverage. The margin is nowhere near the actual value of the commodity. That’s called the Notional Value, which is beyond the scope of this article, but in a few words: It’s the market value times the leverage.
- There are no day-trading limits with futures. The IRS will consider you a day trader if you trade stocks more than three times each day. That does not apply to futures contracts, so you can take quick profits with small intraday swings and get right back in again. Doing this with stocks can sometimes cause “Wash Sale Penalties.” But not with futures.
- Futures trade nearly 24 hours a day. They only pause on weekends and a few minutes at the end of each day for exchange record keeping.
- Most options on futures are European Style and can't be exercised before expiration. So you won’t have your trade closed prematurely because the buyer wants to exercise their option. There are some exceptions—American Style can be exercised anytime, as is the case with most stock options.
- Futures trade like stocks, but you own part of the company when you buy shares of stock. The difference is that futures are contracts for a future sale or purchase. You are obligated to buy or sell the commodity that the contract relates to at a later date at a specific price.
- You tie up margin while holding futures contracts whether you buy long or sell short.
- Remember that you are dealing with a contract. If the trade goes against you and you don’t buy back the option to close the trade, you may have to pay the full price of the underlying commodity upon expiration.
- Pricing on futures is recorded as Marked to Market. That means you have to pay tax on the gains even if you hold a contract into the following year.
Selling short is a way to create income from your trades because options generally lose value as they approach expiration due to time decay.
When you sell short to another buyer, the premium they paid for the option goes to you, and they lose when that premium erodes. The difference between the initial premium they paid, and the lower value when the trade is completed, becomes your profit.
In addition, you can buy a lower-cost option farther out of the money to create a threshold between your possible income and potential loss if the trade goes against you. That is the trick of defining your risk.
Finally, doing this process with futures gives you the extra benefits of better tax treatment, more leverage, no day-trading limitations or wash-sale penalties, and no worries for premature exercise.
- David Kestenbaum. (January 29, 2015). "The Spicy History of Short Selling Stocks" - NPR News
- "Options on Futures" - CME Group
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2016 Glenn Stok
Glenn Stok (author) from Long Island, NY on November 14, 2018:
Mike - Selling covered calls on a long position is another strategy you can use. But if the underlying stock or future goes way down, you will lose much more than the money you'd make on the premium from selling the covered call. So you need to consider that, as you alluded to in your comment.
The method I described in this article locks you in to a fixed max loss, therefore defining your risk as I explained.
Mike on October 25, 2018:
What you think of doing covered call writing ( LONG futures + Short ATM or OTM call)
If it works great return on margin money applied due to ES own internal leverage
BUT if ES goes down the losses are multiplied!
Glenn Stok (author) from Long Island, NY on October 28, 2016:
chefsref - What you just described is exactly what I was talking about. Your emotions get in the way and cause you to make mistakes. I personally don't like mutual funds because they take out fees if they succeed for fail. I can't give you advice since I'm not a licensed broker, so if that's working for you, stick to it.
Lee Raynor from Citra Florida on October 28, 2016:
One thing I never see mentioned in trading advice is emotions. I could trade on paper and be fairly successful but put money on the line and it becomes diffficult to stay disciplined and I make errors. Thus I stay away and merely buy mutual funds.