You may still not completely have understood why this strategy (high probability option premium selling) actually works. That is totally understandable. If someone tells you to invest your hard-earned money in a certain way, you always should be skeptical. In this article, I will try to sum up what exactly our edge while trading is and why this edge will work in your favor long term if you use it correctly.
What is our Edge – Historical Volatility vs Implied Volatility
Implied volatility (IV) can be derived from option pricing models (Black Scholes Model), so when option prices are high, implied volatility is high as well and vice versa. But implied volatility is not the same as the actual historical volatility, it is just an estimate for it. This means implied volatility is the only factor in option pricing models that is not concrete observable. All the other factors are precise and can be measured: strike price, expiration date, the price of the underlying. Therefore, the estimation of implied volatility plays a big role in option pricing.
But actually implied volatility has seldom been the same as the actual historical volatility. The interesting part is that most of the time implied volatility has been higher than historical volatility. Basically, this means that implied volatility has been overstated most of the time and thus options have been priced too high. This again means that option buyers have been paying too much money for their options most of the time and option sellers have been collecting too much money most of the time. See who has the edge here. The option sellers!
You can clearly see this overestimation in the two charts above. The charts show the historical volatility of the S&P 500 compared to the implied volatility. It is very apparent that implied volatility is higher than historical volatility most of the time.
Note that I always said ‘most of the time’. Statistically implied volatility has been higher than actual historical volatility around 80% of the time. This means that the edge is existent for the most of the time, but not all of the time. 20% of the time implied volatility has not been higher than historical volatility and thus there was no edge. This is also one of the reasons why you should keep your positions sizing small. There still is a 20% chance that you don’t have an edge, therefore you should not risk a lot on one trade.
This is also why option selling is not a zero-sum game if done correctly. You often collect more premium than an option actually should have cost and thus increasing your overall profits and therefore winning the zero-sum game.
Additionally, implied volatility tends to revert as soon as it shoots up. You can see that on the chart to the right-hand side. The chat shows the VIX (Volatility Index). The VIX measures the volatility of the S&P 500. The volatility moves quite differently than the price movements seen on other securities. It shoots up and reverts back down very fast. You never really see a slow rise and slow fall down again. All the movements are spikes, some are small and some are big.
What you can take away from this is that it is a good idea to sell options when implied volatility is high. Short options profit from a drop in implied volatility. We just said that as soon as implied volatility shoots up it drops again very fast. So if you sell options when implied volatility is high, implied volatility will likely fall again and the short positions will profit from that.
The Importance of a Long Term Mentality
High probability option premium sellers are just like an insurance company. Insurance companies sell lots of insurance to people but don’t actually hope that those people will need their insurance. So they basically hope that the insurance expires worthless. But sometimes there will be some people, who actually need their insurance and these people create big losses for the insurance companies. But as long as most of these insurances expire worthless, the company will make money. It is rather unlikely that someone actually will need their insurance, so it is quite likely that the insurance companies won’t have to pay out anything to most of their customers.
This is just like our high probability option premium selling strategy. We sell options and hope that they expire worthless. Most of the time they will because they are high probability (far OTM). But sometimes they won’t expire worthless, therefore leaving bigger losses.
When selling high probability options, it is important to have a long-term mentality about it. You can not do this for a few days, weeks or even months. If you want to make money with this strategy, you have to be in it for the long run. Think of it as a bet with a friend. Let’s say you have a 70% chance of winning and he has a 30% chance of winning. If you do this bet once, you may actually lose. If you make the bet 10 times, the outcome still can vary quite a lot from 70/30. But if you do the bet a thousand times, the outcome will be very close to a 70/30 outcome. The more bets you make, the more likely this 70/30 outcome will become.
This is exactly the same for this trading style. If you do one trade, you may lose. If you do 10 trades, you can still lose on most of them. But if you do hundreds of trades, the outcome will be very close to the targeted probability. This doesn’t mean that you have to trade hundreds of times in the next few months. 100 trades may take a year for you or maybe even more. This does not matter. What matters is that you do this for the long term. You cannot try this strategy for one month and tell me that it is not working. You have to be in it for the long run.
Consistency is Key
As you clearly can see, consistency is extremely important for high probability option selling. In the long run, the numbers will eventually work themselves out and you will be profitable. But consistency is only one half of the equation. The other half is trading correctly and not skipping any steps. For example, if you consistently trade bad positions with bad pricing you won’t be profitable. You have to be consistent in trading correctly. This means that you should follow every step in my article and don’t skip anything, which you may find unnecessary. If you only skip one of the steps, it is likely that you won’t be profitable. Just some examples of important things that you can’t skip are: option pricing, being on the correct side of implied volatility, selecting high probability strikes, position sizing etc. Of course, it is hard to memorize all of these things. But they are extremely important. No one expects you to know all of these things by heart either. In the beginning, I would always recommend you to use your notes or some articles to your help. You could use this article and follow all the steps when entering.
If you are reading this article as a part of the intermediate course:
This is the last article of the intermediate course. Congratulations, you completed the intermediate course successfully and are now ready to go out to consistently earn your own money with option trading. If you enjoyed the course, please let me know and share the course so others get to know it as well. If you have any questions left or anything else you want to learn, make sure to contact me. Otherwise, I would greatly appreciate some feedback: did you understand everything; anything I could do better; was this course appropriate to your skill level; etc.
To test your knowledge, I created an intermediate quiz, which you can access here.
After that, you may want to start the advanced course here, check out my other resources here, learn more about specific option strategies in the strategy section (here) or try out some of my personal recommendations (brokers, other trading courses, software, books) here.
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