Ask a Broker

August 2006

This month, Lind Plus Senior Market Strategist Frank D. Cholly discusses selling option premium.

Q: Selling option premium seems rather risky. Is there a safe way to employ this type of strategy?

A: As any type of investment carries risk, it's not possible to say it is "safe" to sell option premium. Unlike buying options, a strategy that has a defined risk and unlimited profit potential, selling options has limited profit potential and unlimited risk. However, there are ways to define your risk if you are interested in this trading strategy, and I recommend the use of spreads. If you think the market is going to move sideways or lower, you can sell call spreads. And if you think the market will go higher, you can sell put spreads. Your risk is the difference in the strike prices, minus the premium collected. For example, a crude oil contract represents 1,000 barrels, and a $1 move is worth $1,000. If you think crude oil is going higher, you can sell the October $72/70 put spread for $800, based on current market prices. If at expiration, crude oil is above $72 per barrel, you will pocket the entire $800, minus any commission costs. The most this spread can ever be worth is $2 per barrel, or $2,000 per contract. Therefore, your maximum risk is defined at $2,000 – $800 = $1,200. If at expiration, crude oil is under $70 per barrel, you'd face this maximum loss.

If the market settles in between $70 and $72, you can determine what your theoretical profit/loss would be. You figure out what the spread would be worth and subtract what you collected. For example, if crude oil settles at $71, the spread would be worth $1. So, your net loss would be $200, because $1,000 – $800 = $200. There is still risk, but it is now defined. This is just one example that can be applied to any market when trading options. Call me if you would like to discuss this topic in further detail, or have other questions.

Frank Cholly is a Senior Market Strategist with Lind Plus. He can be reached at 888-801-9302 or via email at fdcholly@lind-waldock.com.

Kristina Zurla Landgraf is editor of Lind eWire. She can be reached by email at editor@lind-waldock.com.

Futures trading involves substantial risk of loss and is not suitable for all investors.

Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.

© 2006 Lind-Waldock, a division of Man Financial Inc. All Rights Reserved.