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Selling Options... Is It Really One Of The Best Ways To Wealth?

May 22, 2008
Warren Buffet has become something of a modern day financial icon. A beacon to the success that can be achieved in the free markets. He has just been officially named as the richest man in the world, worth a staggering $62 billion. His company, Berkshire Hathaway, has beaten the S&P 500 index by 14.65% over the past 30 years. His investment strategy has been closely examined yet few follow his incredibly successful investment style and as a result miss these stellar returns. Why? Because his investment style is boring. What I mean is long term in nature and rather inactive. It's steady as she goes. It's not a fast paced, action packed ride to riches. It's a slow consistent walk to wealth.

So what does all this have to do with option selling? I'm glad you asked. While Warren Buffet does not sell options to generate his wealth, the concept of option selling is also slow and on the whole rather boring. It is not fast paced nor will it result in a fortune being amassed overnight. But sure as the sun sets at night and rises in the morning it will provide the educated and patient investor with fantastic returns and wealth.

Selling options mean selling either calls or puts (or both). If you recall the definition of an option is a contract which conveys to its holder the right, but not the obligation, to buy (calls) or sell (puts) shares of the underlying security at a specified price on or before a given date. This right is granted by the seller of the option. So it is the option seller who has the obligations because they have sold the rights to the option buyer.

The option seller receives the option premium in return for giving the right to the option buyer. The option premium represents the entire income the option seller can hope to achieve, while his losses are theoretically unlimited. The option buyer on the other hand can only lose the option premium while his return is theoretically unlimited. So why would anyone sell options? Why doesn't everyone just buy options if they have limited loss and unlimited profit potential. The main reason is probability!

Options are very much like a raffle ticket. When you buy a raffle ticket it costs you very little and the vast majority of times you don't win anything. You simply say to yourself that it's cost you only a few dollars and if you were the lucky winner you'd have won big. But why do raffles exist? They don't exist with the winner in mind. They are not altruistic games designed to give more than they take...oh no, quite the opposite. They are designed to offer the raffle holders a nice return on their raffle.

They know that the cost of paying the winner is less than the income they earn. The same rules apply to options. Investors who understand options know that over time that the loses they have to pay to option buyers will be less than the income they earn from the premiums the buyers pay. Studies suggest that between 75% and 80% of options held to expiration expire worthless. This means that option sellers win 75% to 80% of the time!

In addition to probability there are other reasons in that make selling options incredibly attractive as a wealth creation strategy. They include:

* Excellent returns
* Set and forget
* Inbuilt safety factor
* Consistent income
* Win in all market conditions
* Less risk
* Time is on your side

Let's quickly look at each of these in turn...

Excellent returns:

Selling options can provide a knowledgeable and experienced investor amazing returns...returns like 30% to 50% per annum. One of the best ways to look to understand this is to look at a simple example. Gold in February 2008 had just broken $900 an ounce and all the news was majorly bullish for gold. It had already seen a spectacular rise over the past few years but market conditions meant there was every chance it would continue to rise...but most importantly it was not about to fall...at least not beyond a natural pull back.

Someone was willing to buy the 01 June 08 $525 put options for $0.10. I guess they figured "what the hell it's only 10 cents per option...it's worth a punt." Fantastic! I knew that each option I sold represented $10 (100*$0.10) in income and the initial margin was $34 per option. Gold would have to fall by a whopping $400 an ounce in a little over 3 months to be exercised. Now I'd probably have better luck winning the lottery than being exercised on these options (and odds on winning the lottery in the UK are about 14 million to one!).

Now $10 may not sound like much but we need to look at this in terms of return on capital invested. If you can generate $10 on $34 worth of capital invested you are returning nearly 30% over 3 months, which is nearly a 250% compound return per annum. I'll take those odds and that return!

Set and forget:

While I never suggest that you ever invest in anything and totally ignore it from then on, selling options is about as close to this as it gets. When you sell an option you target options that have very low chances of ever being exercised. How? You look for way out-of-the-money options and you apply sound fundamentals. For example, the Dow at the end of Feb 2008 was 12,700 and all the news was incredibly bearish for the markets. Inflation was at record levels, the dollar was in free fall, house prices were plummeting, consumer sentiment was falling, retail sales were stalling, credit markets were frozen, profit warnings were occurring daily and so on.

I was totally comfortable that the Dow was likely to fall, but what I couldn't predict was when and by how much and whether it might go up slightly before it went down. What I was certain was that it was not about to trend upwards. Selling futures, CFDs, spread bets etc requires excellent timing. You might be correct on the overall direction, but without deep pockets you could get stopped out first before the market moves your way. The solution? Sell deep out-of-the-money Dow calls. I sold 15 May 13,500 call options for $140 premium. That means that the Dow would have to rally above 13,640 before I would start to lose money. That is not far from its all time high! At writing the Dow is at 12,200 and my calls are now valued at $17 giving me $123 profit per option. I don't have to watch my calls minute by minute, hour by hour, day by day. I'm totally comfortable that they will expire worthless and I will earn $140 per option.

Inbuilt safety factor:

One of the biggest problems with using stocks, futures, CFDs, spread betting and other financial products that have a linear type return (i.e. their value moves up and down at the same rate).This means that you need to have excellent timing and deep pockets to use them effectively. While I love the adrenalin that these products give me they do not have the type of safety factors that help me to sleep well at night.

How many times have you bought a stock, futures contract etc on the expectation that its price will rise and sure as night follows day the price immediately starts to fall. Soon you find yourself stopped out only to see its price turn around again and rally just as you originally predicted. Essentially these products give you only a small margin of error. If you have more money to play with you can afford to place wider stops, but the fact still remains...you need to time your entry and exist points fairly accurately.

We all know that markets do not move from point A to point B in a straight line...they zig zag their way there...sometimes with quite violent corrections. The more volatile the market the more difficult using linear products becomes, because your likelihood of being stopped out increases. Options give you that margin of error that means you don't need to worry about timing to anywhere near the same degree.

Option sellers have a much higher degree of staying power. They can withstand the zig zagging of the markets much better. For example, if a market is in an uptrend you can sell an out-of-the-money put at a level that gives you a very large level of comfort that the price will never fall to a level where your option will be exercised. Timing the market is much less important.

Consistent income:

Those that sell options can enjoy a regular income month after month. It will not provide you with a 1,000 percent return in a year, but with education, practice and good option selection you can enjoy 30 percent to 50 percent annual returns. But there is a lot to be said for receiving excellent, regular and fairly stress free income. Everyday your options are getting closer to expiry and time decay is eating away at their value. Every month you can receive income from your options expiring.

Win in all market conditions:

It is said that markets go up, down and sideways. In actual fact they go up a little, up a lot, down a little, down a lot and sideways. With linear products you can only win with one third of the movements. For example, if you are bullish, then you will loose if markets go down or sideways (or at least not gain anything). However, if you sell a deep out-of-the-money put option to take advantage of your bullish view then you will win with four out five market movements. In other words you will win if the market goes down a little (it will not hit your put's strike price), stays flat, goes up a little or goes up a lot. You will only loose if the market falls sharply.

Less risk:

When most uneducated investors think about options their first reaction tends to be "that sounds risky". In actual fact options are a lot less risky than trading stocks, futures, CFDs etc. The key reasons why options are less risky are:

* Inbuilt safety factor - options have an inbuilt level of safety because you can sell out-of-the-money options that are very unlikely to be exercised.

* Most expire worthless - we know 75% to 80% of options expire worthless.

* Insulation from market movements - Option prices do not move one for one with the underlying price. In other words if the price of the underlying goes up one point your out-of-the-money option price will only change by a fraction of this, say 0.25 points. This means that if the market moves against you your option price, and thus losses, will not increase anywhere near as much.

* Less likelihood of being stopped out - by selling out-of-the-money options only on extreme market movements will stop you out.

Time is on your side:

Those that buy options need the price to move beyond the option strike price (plus the option premium) before expiry if they are to make money. From the moment they buy an option time is working against them...it is a race that the price can move enough before their time runs out. For the option seller it is exactly the opposite. From the moment they sell their option they have been paid and the option's time is working for them. Every day the option's worth becomes a little less to the option buyer and a little more to the option seller. The option seller does not have the pressure that time will run out...the option buyer always wants more time, while the option seller happily watches time run out.

I hope you'll agree that option selling is a powerful method of generating low pressured, consistent and extraordinary returns. Novices steer clear of options. Those that are uneducated buy options outright. Experts sell options. Writing options is not for everyone...in fact it is only for experts. Don't be put off by that...become an expert...anyone can. Then you can receive the rewards that are just waiting for you.
About the Author
Emlyn Scott is the founder of Rich1Percent , investor and wealth creation author. He is a wealth creation and finance expert with 4 post graduate qualifications and has amassed a multi-million dollar investment portfolio.
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