Mastering Options Trading: How to select the ideal strike price for shorting options in a range-bound market
Shorting options close to support or resistance levels can be your ace in the hole. If the stock remains bound by these levels, you're in for some handsome gains
When it feels like the financial markets are stuck in a holding pattern, going neither up nor down, many traders find themselves wondering how they can still make a profit. This is where options trading, particularly short options, can be a valuable tool in your trading arsenal. In this blog post, we'll delve into the world of options trading in range-bound markets, exploring how short options can capture gains, the concept of time decay, and how to strategically choose between short calls and short puts.
Capturing the Magic of Time Decay
Before we jump into the nitty-gritty of short options, let's first understand the concept of time decay and why it's crucial in options trading.
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What is Time Decay?
Time decay, also known as theta decay, refers to the gradual decline in an option's value as it approaches its expiration date. Think of it as watching a ticking time bomb slowly fizzle out, but in a good way! This phenomenon occurs because as time passes, there is less opportunity for the option to become profitable. An option's value is influenced by two main factors: time to expiration and implied volatility. As the clock winds down, the time value of the option diminishes. Implied volatility also plays a vital role here.
The Role of Implied Volatility
Imagine you have two options with the same expiration date. The difference in their time value is directly influenced by implied volatility. Higher implied volatility leads to higher time value, which translates to greater potential gains from time decay. So, when you're deciding between a call and a put, it's essential to choose the one with the higher time value. Additionally, your choice of strike price, whether it's at-the-money (ATM) or out-of-the-money (OTM), should be based on sensitivity to changes in implied volatility.
Conceptual vs. Empirical: The Great Debate
Now, let's tackle the age-old debate of shorting calls versus shorting puts.
Calls vs. Puts: The Conceptual View
Conceptually, you might argue that calls should have a higher premium than puts. After all, the potential upside in an asset is theoretically limitless, while the downside is capped at zero. However, things aren't always that simple in the world of options trading.
Market Expectations and the Empirical Angle
Market expectations are like a compass guiding your options strategy. They can sway the balance between calls and puts. This is where the empirical angle comes into play. Your choice between a call and a put should primarily hinge on which option boasts the higher time value. But don't disregard the technical side. If the bulls can't seem to gain the upper hand despite the stock hovering near resistance, shorting a call might be your move. Conversely, if the bears are struggling near support levels, shorting puts could be the play.
The Plot Thickens: Support and Resistance
Here's where the plot thickens even further. Support and resistance levels can significantly impact your short options strategy.
Support and Resistance Impact
A break below the support level could expose your short put position to elevated risk. On the flip side, a break above the resistance level could do the same for your short call. It's like dancing on a tightrope. But fear not, because we've got a trick up our sleeve.
Strategic Thinking Near Support and Resistance
Shorting options close to support or resistance levels can be your ace in the hole. If the stock remains bound by these levels, you're in for some handsome gains. But, should it decide to break free, you can swiftly cut your losses. It's all about strategic thinking. And don't forget to choose a strike that's hypersensitive to changes in implied volatility – typically, the ATM strike.
Conclusion
In a nutshell, options trading in range-bound markets requires a keen understanding of time decay, implied volatility, and market dynamics. Armed with this knowledge, you can confidently navigate the world of options trading, even when the market seems to be in a state of limbo. Remember, when the market goes sideways, your profits don't have to. Happy trading!