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Lesson 8: Time and Probability in Selling Options

Time and probability in selling options

Time and probability in selling optionsIn the last article, we have seen the selling of options. In the selling of options, we find the same elements that affect the premium when we buy an option. The strike, more the strike goes away from the current price and less likely is that the underlying will reach that strike and hence lower is the price that the market is willing to accord us. Quite simply: a higher risk is equivalent to a higher premium, a lesser risk equals a lower premium.

The second element that affects the premium is, as seen, the expiration. The more an expiration will be near, much less value will have the premium. This because with a near expiration, the chances that the market does not reach our strike, are greater than expiration and so the market accord us a lesser premium.

Therefore, closer expiration = lower premium, further expiration = greater prize, even though, closer expiration = greater probability, further expiration = lower probability.

The third and last element to determine the premium of an option is the volatility. The greater is the volatility, that is, the change in the price of the underlying in a given, and the higher is the premium that we can get.

In a low volatility period, it is less convenient to sell options. But it should also be said that a low volatility indicates markets little nervous and therefore with fewer sudden movements.

An important indicator of volatility and "meter" of market nervousness is the VIX. The VIX is an index that measures implied volatility in the price of options; it is an indicator that measures the price that operators have been willing to pay to secure the right, but not the obligation, to invest upwards or downwards on the S&P500 index.

In fact, to an increase of the S&P500 corresponds a decrease in volatility, of the VIX. On the contrary, to a decrease of the US index, we see a rise of the VIX. VIX that, for this reason, is also known as the "index of fear".

With the sale of options, we reverse the positive and negative aspects that we saw with the purchase. Now, time and probability are on our side.

Time in selling options is our valuable ally. Now, in fact, time decay is a friend to us. Every day that passes, the option we sell will lose a bit of its value, especially, as we have seen in the previous chapter, over the past 30 days.

Now, we will no longer have the frenzy that the underlying moves strongly in our direction as in buying an option. We can also have a lateral movement of the underlying (resulting in a decrease in volatility) to see the sold option losing value.

The probability of gaining a profit, with the sale of the options, are very high. When we buy an option, basically we will have a 25% chance of bringing home a profit. When we sell, we will get a profit if the underlying falls, horizontally or climbs, but not enough to reach the break-even point. Our probabilities, then, go up to 75%.

When we sell options, it is all a lot simpler starting with the fact that we already know our maximum gain (the premium). We do not have to stress ourselves about how to handle the operation, fought between the "we should close" and "it is better to hold it" (and we let's return to a better quality of life).

Conversely, differently to the purchase of options, in the sale, we will have, as we have said, a potentially unlimited loss. In the next article, however, you will see how to limit it.

 

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