So you’ve been to a seminar or read a book about selling options and you think it sounds simple. It’s not. There are a few considerations when selling options in any market. Here we are going to look at:

1. The option price (volatility)
2. Probability analysis
3. Technical analysis
4. Fundamental analysis

  

1. The option price (volatility)

When traders talk option prices they talk volatility or more specifically implied volatility.  

Definition: implied volatility is the level of volatility needed so an option pricing model (such as the Black Scholes Model) will return a fair value of the option equal to that of the current market price. You could say that implied volatility is the estimate of future volatility that is made by the market as a whole. This is an important point: each option strike has its own level of implied volatility.

High volatility means high option prices. Low volatility means low options price. I believe in selling options only when volatility is on the high side. That is volatility does not have to be extremely high, but just on the high side.

So what is high and what is low? It is all relative to the market you are looking at. To know what is high or low, you’ll need volatility data such as that available on OptionVue.

Source: OptionVue5

2. Probability analysis

Those readers versed in statistics will know there seems to be countless methods for calculating probability. In my market experience however, absolute fine tuning on anyone method is not as important as having a general idea.

Without doubt, fine tuning of probability analysis in other fields is essential. The markets however are different. At the end of most days, they will do their own thing. A general understanding of probability however helps provide a map or an understanding of the risk of a trade. 

I use current statistical volatility, the current market price along with the assumption of a normal distribution to derive a probability of the market moving (or not moving) X per cent over a specific time period. 

Some options software packages offer a probability calculator. OptionVue for example calculates probabilities on its payoff diagrams. I have also built a model for MS Excel. It’s a simple calculator that shows different probabilities over different time frames. If you are good with Excel, it’s pretty easy to knock up a template with the NORMDIST function.

Larry McMillan’s website www.optionstrategist.com also has a basic calculator.

3. Technical Analysis

This article is not about to go deep into the subject of technical analysis. It is a rather large subject and everyone has their own opinion as to what method works and what does not.

The bottom line however is you should be looking for a market that shows overbought signals (for selling calls), or oversold signals (for selling puts) or both (for selling both calls and puts).

My eSignal is set up with daily candlestick charts covering different time frames with different indicators. The candlesticks, and indicators help show overbought or oversold conditions and the moving averages show general trend.

 

My eSignal screen

Indicator	For selling calls	For selling puts
Candlesticks	Shooting stars Hanging man Spinning top Doji Dark cloud cover Tweezer top	Hammer Inverted hammer Spinning top Doji Piercing pattern Tweezer bottom
RSI	Overbought signal above 70	Oversold signal below 30
Moving averages	A strong divergence between the futures price and the moving average level can signal overbought or oversold conditions. This however is often duplicated in oscillators such as the RSI.

These are just guidelines. They do not all have to be present to provide a good opportunity to sell calls or puts. You do need to have some sort of signal though.

I started studying technical analysis when I was still in high school and for a while in my twenties worked as a technical analyst. The best lesson I have learned is to find what works for you and keep it simple.

If you want to know more on this subject buy John J Murphy’s book Technical Analysis of the Financial Markets. While there are dozens of books on the subject, after you read this one, you’ll realize you don’t need to buy them all. It is very well written and broad based.

4. Fundamental analysis

Here I look at the Commitment of Traders Report. This is a weekly report released by the Commodity Futures Trading Commission in the US.

The CoT report shows open interest from commercial traders (buyers and sellers of the actual commodity, e.g. producers and manufacturers) and non-commercials (everyone else such as fund managers, market makers and us).

The report shows total long and short positions held by each party. The general reasoning behind using the report is that the commercial have an inside knowledge of the market. A build up of a large net-short or net-long position can often be an indicator of a reversal in the market.

Commercial positions	Signal
Large net short	Near term top
Large net long	Near term bottom

This is not an essential component to a trade, but it is a good one. The most recent weekly report is available at www.cftc.gov.

I also keep in touch with financial news from websites such as FutureSource (www.futuresource.com) and Bloomberg (www.bloonberg.com). Both these sites provide up to date news and numbers and are free. Following news like this gives you a feel for general sentiment and sentiment gives you are feel of the path of least resistance in the market. Like the CoT report, this kind of stuff is on the end-all be-all, but it does help.

 

Disclaimer: There is a Risk of Loss in Futures Trading
DISCLAIMER HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO SINCE THE TRADES HAVE NOT ACTUALLY BEEN EXECUTED THE RESULTS MAY HAVE UNDER OR OVER COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. THE RISK OF LOSS IN FUTURES TRADING CAN BE SUBSTANTIAL. YOU SHOULD CAREFULLY CONSIDER WHETHER SUCH TRADING IS SUITABLE FOR YOU IN LIGHT OF YOUR FINANCIAL CONDITION. PAST PROFITS ARE NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE. THERE IS A RISK OF LOSS IN FUTURES TRADING.THE INFORMATION CONTAINED HEREIN HAS BEEN OBTAINED FROM SOURCES BELIEVED TO BE RELIABLE, HOWEVER IT CANNOT BE GUARANTEED AS TO ACCURACY OR COMPLETENESS, AND IT IS SUBJECT TO CHANGE WITHOUT NOTICE. IT SHOULD NOT BE ASSUMED THAT THE SEASONAL PRICE TENDENCIES SHOWN HEREIN OR THAT THE SUGGESTIONS REGARDING THEIR USE WILL BE PROFITABLE OR THAT THEY WILL NOT RESULT IN LOSSES. PROTRADER LLC, ITS MEMBERS OR EMPLOYEES ASSUME NO LIABILITY IN CONNECTION WITH THE USE OF THE INFORMATION CONTAINED HEREIN.