The following article was taken from a MTR Investors Group white paper titled "Selling Near Expiration Puts/Calls for Income."
Selling Near Expiration Puts/Calls:
• Capitalize on selling options that lose value rapidly. This allows the option seller to keep the profits when the option expires worthless.
• Short time horizon in an attempt to avoid any adverse moves in the underlying stock/ETF.
• Steady flow of income.
• Suited for traders with short term horizons or income investors.
• Leverage the "weekend effect" by selling options later in the week. Options lose (on average) 0.6% over the weekend. There have been many articles written on this item over the years.
Key Success Areas: Please Note: the reminder of this document will focus on Cash Secured Puts (naked puts) and not naked or covered calls. This will help simply the discussion.
• Commissions: Trading options can be costly. Near term expiration option trades may have less than 3% return, many times the return is closer to 1%. If your broker charges fees such as $12 minimum on option trades this strategy will be less profitable or difficult to make a profit. We recommend you take a look at brokers such as Interactive Brokers (IB). IB has low commissions, fast trade execution, and cover all markets.
• Market Environment: Selling puts is best when the market is in an uptrend. Selling naked calls is best suited in a down trend. Both have risks. Use our Stock Market Scout to determine market trend.
• Stock Selection:
• Stocks in an uptrend, or flat, and above key support areas (see later for an example)
• Avoid earnings announcements dates
• Start the selection process using our Expert Option Search
• Option Selection: Using our Expert Option Search engine to select options (sample criteria)
• Expire in one to three weeks (best to keep the range under two weeks).
• Have a low Probability of Assignment (POA). This helps to put the odds in your favor that the option will expire worthless.
• No earnings period during the option selling window
• Watch out for extremely high return on investment (NYSE:ROI). This means the underlying stock is very risky and reduces the odds of the option expiring worthless.
• Select options that are far out of the money (OTM). This is indicated by the "Moneyness" feature in the scanner. The further negative the OTM value the better. For example if a an option is 15% OTM it means the stock would have to drop 15% before you would be assign on the put and take a loss.
• Sell options later in the week. Historical evidence reports that on average options lose 0.6% over a weekend. Take advantage of the loss of value by selling options later in the week.
• Select high Downside Protection (DSP). Example: If DSP is 20% it means the stock would have to drop 20% before you are assigned and take a loss.
Option Selection: Note: This documentation was made without knowing the results of the example discussed below. Please read the disclaimer in this document. This is not a recommendation to buy or sell any security. This is for informational purposes only.
Search Settings: Set the expiration dates for options that expire in the next two weeks. The sooner the expiration typically the better. Some key selection criteria listed below.
• Expiration Dates: Select near term expiration dates.
• Probability of Assignment (POA): The probability you will be assigned the stock. Select the lower the better to increase the odds of the option expiring worthless and not being assigned the stock.
• Moneyness: This is an indication of how far away the option strike price is from the stock price. For example if the moneyness is -10% (negative 10%) it means the stock would have to fall 10% before you took assignment and a loss.
• Other Features: Other items such as downside protection (DSP) and Return on Investment (ROI) can be used to limit results. Mouse over any "?" on the page below for help information.
Search Results: We will focus on the 5/10 expiration (1 week from the date of this writing). Click on the drop down icon on the date filter and select 5/10. Then sort by Moneyness High to Low.
For example, looking out two weeks, the first group of options are selling 52% out of the money with a 2% ROI for two weeks.
In this example we randomly selected Facebook. For no other reason than people know the name.
Option Return/Trading: We will take a look at the PUT option at the $23.50 strike price.
• It 14.3% out of the money, has a 1% ROI, and POA is at 9%. Indications show that the odds favor the option will expire worthless.
• The bid is .15 cents ($15.00) this means a gain of $15 per option sold.
• If you sold three options this would be a potential gain of $45 for two weeks.
• You need $6,900 in reverse to sell 3 puts. (Strike Price * 300 Shares) 23 * 300 = $6900. This amount is held in "reserve" in your account until the options expire worthless, you are put the stock, or close out the trade.
• $45 may not sound like much but… Let's say you made 4 trades a month, 48 trades a year and in a perfect world they all worked out (remember there is no guarantee in the markets) this would amount to $2,160 year. Based on using $6,900 as leverage in "reserve" the yearly return is 33%.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.