3. Selling Options versus Buying Options

Selling (writing) covered calls, along with selling put options are strategies that have gained some attention in recent years. Let's explore some basics behind these concepts.

Options traders often focus their attention on time decay. Some traders refuse to initiate positions that have negative time decay because (their reasoning goes) they "don't want to slowly bleed to death." Other traders shy away from positions that have positive time decay because they fear market movement will hurt them.

Is one approach correct and the other wrong? I think both are wrong because both are exclusionary. That is, both approaches preclude ever using the other technique.

I believe that deciding the type of trade to initiate should be made only after evaluating other factors. Once those evaluations are complete, you'll know what type of trade to do. Sometimes the answer will be to establish a position that sells premium (positive time decay) while other times the answer will be to buy premium (negative time decay). I'll explain my rationale below.

First of all, it's a mistake to look at time decay in isolation. Time decay is only one of three variables affecting position performance, and I believe two other variables are the key ones to analyze and act upon: those variables are implied volatility and statistical volatility.

It's desirable to capitalize on extreme levels of implied volatility by buying options in markets having low implied volatility and by selling options in markets with high implied volatility. Why? Because studies have shown that implied volatility will eventually revert to its long term average. So abnormally low implied volatility will eventually increase and unusually high implied volatility will eventually decline. This makes sense to me because emotional extremes must eventually return to a more normal state.

You can choose from various types of options spreads when buying or selling implied volatility, however, before deciding anything it's important to take volatility of the futures contract into account. This means you must review statistical volatility because it measures price movement of the underlying futures.

It would be foolish to buy options in a market that's complacent in its behavior, just as it would be reckless to sell options in a market that's trending or chopping back and forth in a volatile fashion. Instead, it seems logical to expect a market will continue to behave just as it's been acting recently.

So using this framework, you want to identify those markets which currently are:

1. non-volatile and which possess high implied volatility. These are markets for initiating short straddles, short strangles, ratio spreads, or long condors (a credit call spread along with a credit put spread).

2. non-volatile and which possess low implied volatility. These are markets for initiating calendar spreads.

3. volatile and which possess high implied volatility. These are markets for initiating reverse calendar spreads.

4. volatile and which possess low implied volatility. These are markets for initiating long straddles, long strangles, ratio backspreads, or short condors (a debit call spread along with a debit put spread).

This is where the Data Base Survey (DBS) function of OptionVue5 enters the picture. In a matter of minutes you can complete and print surveys which allow you to identify the markets for each of these categories.

"Knowledge is power and all traders can benefit by continually bolstering their knowledge base. I hope to contribute in that regard."  Paul Forchione