No matter how you define risk in specific terms, the concept of risk always involves losses. High risk is associated with a greater-than-average possibility of loss. By that definition, selling options could be one of the lowest risk strategies an investor can use.
Options have a reputation for being high risk and investors are often told that "80% of options traders lose money." I've never been able to find a report that validates that number.
I think of options as an investment where there will be an equal number of winning and losing positions. This is simply a result of the way options are designed. Whenever an option is bought, someone else must be selling, and one side of the trade will be a winner while the other party will face a loss.
Options give the buyer the right to buy or sell 100 shares of a stock or an ETF at a predetermined price (known as the exercise price) before a specific date. Because they have an expiration date, on that date the option buyer will have either a gain or a loss and the trade is over either way. There are only two possible outcomes, and if the buyer wins, then the options seller must have a loss. Conversely, when the options buyer loses, the seller wins.
Studies (and experience) show that the options buyer does not have a 50/50 chance of winning. They actually have a very high probability of losing. A study done using Chicago Mercantile Exchange (CME) data showed 83% of all options on stock indexes expired worthless.
Remember that there is a winner for every losing options trade. If the buyer loses on 83% of these options that means the sellers win that often.
We can even tilt the odds in our favor slightly more by looking at whether call or put selling would be more profitable. A call option gives the buyer the right to buy the underlying stock and a put option gives the buyer the right to sell the underlying stock. Call buyers profit when prices go up, while put buyers profit when prices decline.
CME data showed that 60% of calls expired worthless while 94% of puts expired worthless. This data shows that selling puts has a high probability of success.
When you sell a put, you will generally sell it at an exercise price that is below the current market price. Unless the price of the underlying stock or ETF falls below the exercise price, the put will expire worthless.
To minimize the risks of put selling, you should only sell put options on stocks or ETFs that you would like to own. For example, if SPDR S&P 500 ETF (NYSE: SPY) is trading at $240 and you would like to buy it on a 10% pullback, you could sell a put at $216 that expires in one to two months and earn income while waiting to buy at your desired price. The caveat is that if SPY falls more than 10% you will still have to buy it at $216.
I believe one reason the success rate for put sellers is so high is because the market is dominated by professionals. They know the fair value of the puts they are willing to sell and take trades only when the time is right. Individual investors can easily profit from selling puts just like the professionals, but this strategy requires doing some homework.
An SPY put with an exercise price of $230, for example, will have a higher price than a put with an exercise price of $116, but the higher exercise price is more likely to be exercised. It is usually best to use puts that are at least 10% below the current market price to earn a high amount of income and help ensure you only buy the underlying stock or ETF at a bargain.
Trading options could be a way to increase your income by hundreds or even thousands of dollars every month, but you need to study the market before making trades. Consider selling put options if you are looking for an income strategy that offers low risk.
Editor's Note: Each week since February 2013, I have provided my Income Trader subscribers with a low-risk put or call selling opportunity. And so far, 96% of my trades have been winners. My track record now sits at an astonishing 136 for 140. You can see how I've done it here.
This article originally appeared on Street Authority.