How is it possible to capture more premium than what you sold an option contract for? The answer lies in the manner in how you construct your option trade (i.e., put spread vs. custom put spread). A custom put spread leverages a minimal amount of capital, defines risk, and maximizes the return on investment while enabling traders to capture greater than 100% of the option premium. Custom put spreads are ideal when engaging in options trading for many reasons. This type of trade is great to layer into a long-term successful overall options strategy which includes risk-defining trades, staggering expiration dates, trading across a wide array of uncorrelated tickers, maximizing the number of trades, appropriate position allocation, and always being an option seller to bring premium income into the portfolio continuously.
Using a combination of custom put spreads and put spreads, a total of 91 trades were placed in May, June, July, and thus far in August as the markets rebounded after the COVID-19 lows. During this timeframe, all 91 trades were winning trades to lock-in a 100% option win rate with an average income per trade of $185, an average return on investment (ROI) per trade of 7.5%, and overall premium capture of 99.4%. An options-based portfolio can offer the optimal balance between risk and reward while providing a margin of downside protection with high probability win rates. As the market continues to rebound, optimal risk management is essential when engaging in options trading as a means to drive portfolio performance (Figures 1, 2, and 3).
Figure 1 – Average income per trade of $185, the average return per trade of 7.5% and 99.4% premium capture over 91 trades in May and June
Figure 2 – Average premium capture per trade of 99.4% with numerous trades with greater than 100% premium capture using a custom put spread strategy
Figure 3 – Average return on investment (ROI) per trade of 7.5% using a risk defined strategy via leveraging a minimal amount of capital to maximize returns
Premium Capture
When you sell a put option contract, you receive premium income in exchange for selling the option as a result of taking on the potential risk of being assigned shares. You agree to buy shares at a specific price by a specific date in exchange for a premium. If the shares remain above this agreed-upon price by the expiration date, then the option expires worthless. The expired option results in 100% of the premium being realized for a gain with any and all risk of being assigned shares going away as well. Let’s say you sold an option for $1.00 per share at a strike of $95 with an expiration date of one month from now. You would receive $100 upfront in premium income since options trade in blocks of 100 shares. If the underlying shares remain above $95 per share when the contract expires, then you walk away, capturing 100% of the premium as a realized gain ($100/$100), and now any capital that was leveraged for this trade is freed-up and can be repurposed for subsequent trades.
Custom Put Spread
If you take in a premium when you sell an option and it expires worthless, then you capture 100% of the premium. So how is it possible to capture more premium than what you sold the option contact for? The answer is a custom put spread. This type of trade leverages a minimal amount of capital, defines risk, and maximizes ROI while enabling traders to capture greater than 100% premium.
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A custom put credit spread strategy involves selling a put option and buying a put option while collecting a credit in the process. When selling the put option, the premium is collected and simultaneously using some of that premium income to buy a further dated put option at a lower strike price. The net result will be a credit on the two-leg pair trade with defined risk since the purchase of the put option serves as protection.
By selling the put option, you agree to buy shares at the agreed-upon price by the agreed-upon expiration date. By buying the put option, you have the right to sell shares at the agreed-upon price by the agreed-upon expiration date. Thus risk is defined, and capital requirements are minimal. Even if the stock goes to zero, you have the right to sell the shares via buying the put protection leg.
Capturing Over 100% Premium Income
The custom put spread trade set-up has two legs. The initial leg is a sell-to-open at the higher strike price to receive a premium. The second leg is a further dated put protection leg that is a buy-to-open at a lower strike price.
As expiration nears in a custom put spread, you can buy-to-close the higher strike for a small debit. The further dated put protection leg has a week remaining in the contract; thus, time premium remains, and you can sell-to-close for a credit. The credit taken in to close out the protection leg will exceed the debit required to close the higher strike leg. The result will be greater than 100% premium capture since you’ll net more premium than initially received upfront when selling the pair trade (Figure 4).
Overall Options-Based Strategy
Options are a leveraged vehicle; thus, minimal amounts of capital can be deployed to generate outsized gains with predictable outcomes. A combination of put spreads and custom put spreads is used as the foundational strategy as an ideal way to balance risk and reward in options trading. This strategy involves selling a put option and buying a put option while collecting a credit in the process. When selling the put option, the premium is collected and simultaneously using some of that premium income to buy a put option at a lower strike price. The net result will be a credit on the two-leg pair trade with defined risk since the purchase of the put option serves as protection.
An Effective Long-Term Options Strategy
A slew of protective measures should be deployed if options are used as a means to drive portfolio results. One of the main pillars when building an options-based portfolio is maintaining a significant portion of cash-on-hand. This cash position provides the ability to rapidly adapt when faced with extreme market conditions such as COVID-19 and Q4 2018 sell-offs. When selling options and running an options-based portfolio, the following guidelines are essential.
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1. Trade across a wide array of uncorrelated tickers
2. Maximize sector diversity
3. Spread option contracts over various expiration dates
4. Sell options in high implied volatility environments
5. Manage winning trades
6. Use defined-risk trades
7. Maintains a ~50% cash level
8. Maximize the number of trades, so the probabilities play out to the expected outcomes
9. Continue to trade through all market environments
10. Appropriate position sizing/trade allocation
Conclusion
Options are a leveraged vehicle; thus, minimal amounts of capital can be deployed to generate outsized gains with predictable outcomes. A total of 91 trades were placed in May, June, July and thus far in August as the market rebounded after the COVID-19 market lows. During this timeframe, all 91 trades were winning trades to lock-in a 100% option win rate with an average income per trade of $185 and an average return on investment (ROI) per trade of 7.5%.
A combination of put spreads and custom put spreads underpins this options-based strategy. These types of trades are an ideal way to balance risk and reward in trading. The overall options-based portfolio strategy is to sell options that enable you to collect premium income in a high-probability manner while generating consistent income for steady portfolio appreciation despite market conditions. This options-based approach provides a margin of safety while mitigating drastic market moves and containing portfolio volatility.
Options trading is a long-term game that requires discipline, patience, and time. Maintaining liquidity, spreading out expiration dates, maximizing sector exposure, maximizing ticker diversity, risk-defining trades, and continuing to sell through all market conditions is essential. Continuing to maximize the number of trades is essential, so the probabilities reach their expected outcomes, given enough occurrences. Put spreads and custom put spreads offer superior risk mitigation in the event the underlying security moves against you during the option lifecycle while easily achieving greater than 100% premium capture throughout the process.
Thanks for reading,
The INO.com Team
Disclosure: The author holds shares in AAPL, AMZN, DIA, GOOGL, JPM, MSFT, QQQ, SPY and USO. The author has no business relationship with any companies mentioned in this article. This article is not intended to be a recommendation to buy or sell any stock or ETF mentioned.
Your logic is sound but how does one buy a 3rd put without also writing a 4th at the prices for vertical spreads? Do you go to the single pricing? How does that would work? What am I missing?
Hi Fred
It's a simple two-leg put spread with a further dated protection leg. There's only two legs, the first is sell-to-open and take the in the premium and using so of that premium for a buy-to-open protection leg. This is risk defined and maximizes ROI. If you want to do 4 leg then you're talking about iron condors with spreads on both the put and call sides.