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Selling options for premium feels like easy money – until the market reminds you it isn’t.
On the surface, the income strategy seems simple enough. If the market behaves as you expect, the options you sold expire worthless, and you get to keep the premium.
But the stock market has a habit of making risky strategies look much safer than they really are. If you don’t fully understand your obligations when selling options, you can see significant losses.
And those risks came to the fore during last Friday’s massive selloff…
After bottoming out on March 30, the major indexes headed in just one direction… up.
As investors piled back into AI stocks, the S&P 500 clocked nine successive up weeks. The Nasdaq had just one down week over the same time (and only just). Investor excitement around SpaceX’s IPO and anticipated future listings by Anthropic and OpenAI only added to the hype.
Yet at the same time, volatility remained remarkably subdued, resulting in lower option premiums.
Traders wanting to generate income from selling options found themselves collecting less and less premium. And that often leads to a trap.
To maintain the same level of income, traders would have to take on more risk. For example, instead of selling one option contract, they might decide to sell two or three. Or they might sell options closer to the market, increasing the chance of being exercised.
Regardless, they start selling options without being adequately rewarded for the risk they’re taking on. The market moving ever higher gives a false sense of security… right until it doesn’t.
And that ties us back to Friday’s action… when the Nasdaq and S&P 500 abruptly dropped 4.2% and 2.6%, respectively.
One popular option strategy in a bull market is selling put options. In short, you receive a premium upfront in exchange for agreeing to buy a stock if it falls below the option’s strike price.
When markets were rising, as they were from March 30 onwards, it surely felt like easy money. As each week passed, the options expired worthless, and the seller could pocket the premium.
But there’s a catch…
The profits from selling puts tend to be small and frequent. But losses can be large and sudden. Just one hit could wipe out the profits accumulated over months.
That’s why it’s vital to understand risk-adjusted returns. It’s not about how much premium you’re collecting; it’s about whether that premium adequately covers the obligation you’re taking on.
Consider someone who collects $5 for selling a put option on a stock with a $100 strike price. They’re collecting $500 (an option contract is for 100 shares). In exchange, they’re obligated to buy 100 shares if the stock falls below $100 and the option is exercised.
If the stock keeps rising, they might grow confident and sell even more contracts, collecting more premium along the way.
But then there’s a big selloff, and that stock falls to $70…
The trader is still obligated to buy 100 shares at $100 per share… per contract. That’s a $30 difference ($100 strike minus the $70 current price).
The $5 in premium received offsets that loss slightly. But they’re still facing a potential $25 loss (or $2,500 per option contract).
Especially if that trader had ramped up to selling multiple contracts, the loss can easily snowball into a huge hit. The same option-selling strategy that looked safe just a day or two before has suddenly revealed some dangerous teeth.
That’s why I’ve remained cautious as this runaway rally soared. Option premiums haven’t adequately covered the potential risk.
And the risk I just described is why I never write a put option on its own. I always add another leg to my trade to cap any potential losses. While it reduces the premium I receive, I’d much rather sacrifice some profit than be exposed to potentially explosive losses.
The main takeaway? Collecting premium feels like easy money… until it doesn’t. Managing the risk of what you’ve sold matters far more than maximizing the credit you receive.
Happy Trading,
Larry Benedict
Editor, Trading With Larry Benedict
Reading Trading With Larry Benedict will allow you to take a look into the mind of one of the market’s greatest traders. You’ll be able to recognize and take advantage of trends in the market in no time.
