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Option writing (selling) is one of the most successful trades around the globe as history has it. However, success comes at a cost. The cost is of very high risk profile.
Strike selection plays a very big role in Option Writing trades. What strike we select decides the amount of returns we will be making as well as the amount of risk that we will have to bear.
Directional move is the enemy of the Option writer. Now, we all know that closer the strike is to the current market price more will be the sensitivity to the directional move. One way to distance from this is by being one of those writers who Sell both Call and Put. Remember, there will be one option that will be positively impacted by the directional move and another one will be negatively impacted.
If the underlying rises
Call Sold will go in losses (as premium will rise)
But, Put Sold will be in profits (as premium will fall).
While this is a good strategy, one must remember that being the characteristic of the option it has very little room to fall but big room to rise. In other words, the money that Profit from favorable move will be always lower than equally opposite unfavorable move.
While selling both Call and Put partially compensate the directional move led losses, we can do more things to bring the improvement into our Option writing.
How?
By Improving the Strike selection.
1st Improvement
We go few % higher and equal % lower in selecting strikes. More Optimal way of selecting the strikes is that in case if the market is a little too volatile, we would go farther making that % distance from current market price a little bigger and in quitter times like recent, we would keep the strikes closer.
How do we do that?
Simple volatility indicators like India VIX can give us a good insight. However, there are easier ways too. A lot of people use Bollinger Bands (Popular technical analysis indicator). These bands are available in most of the technical analysis software. They do show reduction and increment in the distance between the bands. This can be a good indicator.
2nd Improvement
Here the improvement that can be done to make the strike selection more optimal is by bringing in the trend into the strike selection. All of us have many ways to identify the direction of trend. It is stock market after all . Remember the sensitivity we discussed.
Now if we choose a farther strike Call and closer strike Put by adding our expectation of uptrend into the option writing, farther Call will have lower sensitivity and lower negative impact and could match the positive impact on the closer put. This could help us optimize the writing by minimizing the directional impact.
3rd Improvement
3rd improvement is more to do with choosing the strikes with right expiry. The best selection for option writing is the closest expiry. The reason is very simple. One must always remember.
20 Days to Expiry Option Premium < 10 Days to Expiry Premium X 2.
These are a few improvements that can improve profitability in Option Writing simply by reducing the Risk element.
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