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Let’s delve a bit into one of the more advanced options concepts: selling time premium. Traders that are new to options often begin with just Call/Put purchasing and perhaps Covered Calls. Then they begin to wonder what the other side of the options transaction is like.

Remember that for every single listed option trade, there is a buyer and a seller — usually it’s the public buying options and the Market Makers handling the order flow and maintaining an orderly 2-sided market.

Right now, with 1 to 2 weeks to go before a monthly options expiration (the new Weekly options are a whole other story) is often a very attractive time to sell option premium due to the rapid decay that will occur by next Friday’s close.

First, I’m generally not a fan of ever selling “naked” options (not covered by another option or underlying) unless perhaps you run a giant hedge fund. Your risk can be unlimited, the margins are very high and you can have 10 winners in a row and 1 big loser can wipe out all your profits and more.

So one of my preferred ways to garner that rapid decay in time premium and Theta is to sell front month out-of-the-money Call or Put spreads ahead of expiration. This is known as a Credit Spread, also a Vertical Call or Put Spread. The “spread” part means that we are selling one option and buying another in the same amount, in 1 simultaneous transaction and receive a net “credit” (cash) for the trade (we’ll also utilize Debit Spreads in a similar in the BigTrends ETF Tradr program in 2011, but that will be examined at a later date.)

So if you are looking at doing this, you need to find a stock/index/ETF that will either go your direction or be flat heading into Expiration. That’s the nice thing about these Credit Spreads is that you get a “cushion” within which the security can move against you and you can still make the maximum profit on it.

Ok, so for a real-life example with real-time prices — the S&P 500 Index ETF (SPY), which basically mimics 1/10 the performance of the SPX index. Let’s assume you are Bullish/Neutral on SPY heading into next Friday’s final trading day for January options, the 21st.

SPY is currently at 128.50. The SPY has 1 point increment on its strike prices and is very liquid with small bid/ask spreads, so securities like this are particularly attractive to sell premium on — you don’t give up as much “edge” to the market makers with wide big/ask spreads and execution problems.

And while the SPY itself is fairly high-priced for a stock, being above 100, the implied volatilities on its January options really aren’t that high. The At-The-Money (ATM) Straddle is only trading around a 13% implied volatility currently.

So with our Bullish/Neutral theoretical stance (not a trade recommendation), we would be looking at January Out-of-The-Money (OTM) Put spreads to sell. If one is banking that the SPX itself will go out above the key 1,250 level next week, we could look at selling the SPY Jan 125/124 Put spread.

Currently, this spread is 0.07 by 0.11 — the max risk is the premium received minus the difference between the strikes — so in this case if we sold it at 8 cents, the max risk is 92 cents. That’s a 8.7% return on risk in 1.5 weeks, also with a price cushion of approx 3.6 points on the SPY to breakeven level of 125 (around 2.8% downside protection).

That return is a bit lower than I usually prefer for my front-month credit spreads (i prefer 15% to 60% max potential gains), but since 125 is such a key technical/psychological level, let’s just use this as a theoretical example. Basically in this case, if we sold this 1 point spread for 0.08 ($8), then $92 is required for each spread by most brokers as the margin required (maximum risk).

If the stock goes out above 125 next Friday, the 2 options expire worthless and you keep the $8 credit received for a quick gain. You also have that cushion whereby the SPY can go almost 3% against you and you’ll still profit. That’s why credit spreads in this manner have a high probability of success – so you don’t have to be correct in your directional pick, you just can’t be dead wrong. Your own personal risk/reward comfort level should help determine what spreads you feel most comfortable selling.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: A Closer Look at Selling Option Premiums Ahead of Expiration