Short option trading might still be a solid strategy
Now that we’ve discussed some of the risks and challenges of short option trading, let’s focus on the positive. The primary advantage of an option selling strategy is its ability to generate profits regardless of market direction. Further, an option seller can be wrong in regards to market direction and still make money. It is the only strategy that I’m aware of that offers such a high margin of error. Likewise, the odds of making money on any given trade are rather high. Generally speaking, an option seller can expect to make money on anywhere from 60% to 90% of trades. This is dramatically higher than most futures trading strategies which generally produce win/loss ratios of 50%, or worse. Similarly, long option traders might be lucky to win 10% to 20% of their trades. With these stats, it is easy to see why some traders are lured to an option selling strategy.
Naturally, a strategy that provides traders with such high odds of success on each venture must come with some sort of caveat…and it does. Losses on the few losing trades can easily engulf any profits made on the winning trades. Hence, it will take careful consideration and planning to successfully implement a short option strategy.
Here are a few ways to increase the odds of avoiding the “big loss”
Unless there is an obvious direction, sell strangles
Selling both a call and a put, known as a short strangle, is a method of increasing the premium collected while arguably increasing the odds of success. The favorable odds come from the fact that the trade can only lose on one side, but preferably neither. Risk exposure on one side of the strangle is partially hedged by the additional premium collected on the other side of the strangle. Simply put, the break-even point is shifted outward making it less likely for the trade to lose money (with all else being equal). With that said, not all market conditions are ideal for strangle. For instance, a market trading at an all-time low is prone to massive buying should the trend change. On the other hand, if there is no trend-change one directional trade could also put the short strangle in jeopardy. The ideal market to sell an option strangle is one that is neither at support nor at resistance, is not overbought nor oversold, and has a relatively equal probability of going either way.