I just want to know what you think about generating income from selling far-out-of-the-money index options, such as on the Amsterdam index or SPX index, I read one book that suggests selling FOTM index put options with expiration of 2 to 6 months.
I think this is safe because the far strike price and far expiration, combined with our exit strategy of getting out of the position if the strike price is touched, or the premium doubles or triples.
In my opinion, 2 is is better way -- in fact the only way -- to think about this strategy. Unless you are a very experienced trader who never has a problem with risk management, don't sell naked index put options. You can still sell OTM puts on stocks that you want to own -- as long as you have the cash to make he purchase.
Just look at the world as it is today. What would happen if terrorists were able to assassinate two or three world leaders at the same time? Or were able to explode a nuclear bomb in NY or London? Or if Greece had defaulted and had to drop out of the Eurozone? What about a nuclear confrontation between some long-time enemies? Not only would the stock market decline -- resulting in a loss -- but the implied volatility would double or triple -- and that would increase the price of the naked puts by a very large amount.
People who adopt this strategy always think that they can exit when the option price doubles or triples. And most of the time they can. But if something bad happens, the markets will be in panic mode. The majority of traders will want to buy puts to protect their assets, thereby increasing the price of all options. Your loss in this situation would be huge. Play with an option-pricing calculator to see just how much cash is on the line.
In October , implied volatility moved as high as That may not happen again, but when there is panic, traders who are short put options suffer. The problem is that one such loss could bankrupt your account -- and possibly leave you in debt to your broker.
I understand that this is unlikely on any given day, or any given month. But if you are always short some put options, then you are always exposed to this high-risk situation. Sure you can use this strategy if you still like the idea, but you have to expect to take a good-sized loss every few years or so. There are more such market crashes coming in the future. We just do not know when. That brings on the temptation to sell more puts that you had been selling previously.
The more money you make, the more you are going to feel safe -- and that is when a trader tends to ignore risk and may increase position size. And when you own a large position, the unthinkable scenario could result in a loss that wipes out a lifetime of savings. Too risky for me. That is why I always sell put spreads and not naked short options. The profits are less, but there are never any catastrophic losses.
Updated February 14, Question from a reader:More...