See discussions, stats, and author profiles for this publication at: https://www.researchgate.

net/publication/233786567

Generating Profit Using Option Selling Strategies

Conference Paper · August 2012

DOI: 10.1109/BIFE.2012.45

CITATION READS
1 6,603

1 author:

Kin Keung Lai

City University of Hong Kong
763 PUBLICATIONS   10,643 CITATIONS   

SEE PROFILE

Some of the authors of this publication are also working on these related projects:

National Natural Science Foundation of China (NSFC) under grant No. 71473155 View project

Deep learning applied to time-series View project

All content following this page was uploaded by Kin Keung Lai on 17 January 2019.

The user has requested enhancement of the downloaded file.

 2012 Fifth International Conference on Business Intelligence and Financial Engineering
Generating Profit Using Option Selling Strategies
Stanley Choi, Dong Gang
Head & Shoulders Global Investment Ltd.
Cosco Tower
183 Queen’s Road Central, Hong Kong
Hong Kong SAR, China
donggang59@gmail.com
Abstract—In this paper, option selling strategy is discussed
which is different from traditional equity and commodity
trading strategies. Option selling strategies can achieve various
non-linear Profit & Loss (P&L) graphs instead of traditional
linear P&L graph. Option sellers make money through taking
advantage of time value of option. Option sellers collect
premium as time elapses. Selling straddle is proposed in this
research. The strategy is back-tested using Hang Seng Index
(HSI) Option data. The return of the proposed strategy is
compared with HSI and its performance greatly outperforms
HSI. The great profit generating ability of option selling
strategy is verified in this paper.
Keywords-component; Option; trading strategy; option
selling; straddle
I. INTRODUCTION
For more than a century, stock and commodities traders
have fueled price rises and falls at exchanges across the
globe. Fortunes have been made and lost — some over the
course of a lifetime, others over the course of an hour. The
rules of the game are simple. Investors either buy low and
sell high or sell high and buy low.
Investors and speculators try to profit today the same way
their ancestors did many generations ago. Whether they are
trading stocks or commodities, or currency, the basic concept
of investing has not changed — the bulls buy and hope the
market rises, the bears sell and hope it falls.
Traditional assets (e.g. stock and commodities) have
linear payoffs, i.e. the profits as well as losses for the buyers
and sellers are unlimited. Options have non-linear payoffs.
Theoretically, option buyers take limited risk and gain
unlimited profit, while option sellers have limited profit and
unlimited risk. Options allow investors to create unique
strategies to take advantage of different characteristics of the
market — like volatility and time decay.
Options are basically contracts between two parties, the
buyer and the seller, giving the former the right to purchase
or sell some underlying asset, with specification of price and
validity period. The specified price is called the strike price
and the validity period is also called the expiry date. Options
are called derivatives for two reasons: the first is that option
trading is derived from stock and futures trading; and the
other is that option price always depends on (derives from)
the value of the underlying asset, be it stock, index or some
commodity.
978-0-7695-4750-3/12 $26.00 © 2012 IEEE
DOI 10.1109/BIFE.2012.45
Kin Keung Lai
Management Sciences Department
City University of Hong Kong
Hong Kong SAR, China
mskklai@cityu.edu.hk
Option buyer (holder) can exercise the prepaid option to
buy or sell some financial product within an agreed time
interval but is not obliged to do so. On the other hand, option
seller (writer) is obliged to agree to either of the buyer’s
decisions.
In addition to non-linear payoffs, there are four
key advantages (in no particular order) that options may
give an investor: they may provide increased cost
efficiency; they may be less risky than equities; they have
the potential to deliver higher percentage returns; and they
offer a number of strategic alternatives.
Options have been around for more than 30 years, but
options are just now starting to get the attention they deserve.
Many investors have avoided options, believing them to be
sophisticated and, therefore, too difficult to understand.
Many more have had bad initial experiences with options
because neither they nor their brokers were properly trained
in how to use them. The improper use of options, like that of
any powerful tool, can lead to major problems. Finally,
words like "risky" or "dangerous" have been incorrectly
attached to options by the financial media and certain
popular figures in the market.
In this research, the focus will be option selling
strategies. Although option selling strategies are associated
with limited profit and unlimited risk, there is strong
evidence to support the notion that option sellers have more
chances to profit than option buyers.
Futures magazine published a study in [1] regarding the
proportion of options that expires as worthless. The study
tracked options in five major futures contracts: the Standard
& Poor’s (S&P) 500, the Nasdaq 100, Eurodollars, Japanese
yen, and live cattle. It was conducted over a three-year
period from 1997 to 1999. The research came to three major
conclusions.
1) On average, three of every four options held to
expiration expire worthless (the exact percentage was
76.5%).
2) The share of puts and calls in options that expire
worthless is influenced by the primary trend of the
underlying market.
3) Option sellers still come out ahead even when they
are going against the trend.
177
 Second, no matter what the market is doing, time is
constantly, albeit slowly, eroding the value of the option.
While the option can gain value from market movement,
time will always be with option sellers, working for them
and against option buyers.
Third, one critical aspect for success in futures or stocks
trading is able to time the market. Because of the leverage
involved in trading futures or stocks, mistiming the market
probably costs traders more losses than incorrectly picking
the ultimate direction of prices. Selling options avoids the
needs of perfect timing of the market. Suppose in a bull
trend, a seller simply can sell options far beneath the market,
allowing wide price fluctuations within the trend that will not
dramatically affect her position. In this way, she can sell
options on an up or down day without the need of perfect
timing. The fluctuation in her option price generally will be
substantially less than if she were in futures position. Thus
option seller has significant holding power in the market and
is able to ride out short-term market fluctuations.
Finally, regardless of the label of unlimited risk in selling
short options, option selling risk can be just definable and
controlled as any other type of futures or stock trading risk.
The risk of options selling can be controlled by future, stock
or even option.
The rest of the paper is organized as follows: II) reviews
relevant literature; III) analyzes risks associated with option
trading; IV) analyzes typical option selling strategies and
their corresponding risks, and proposed option selling
strategy; In V), empirical experiment is conducted to back-
test the performance of the proposed strategy. Its
performance is compared with HSI.
II. LITERATURE REVIEW
More and more people realized the benefits of option
selling. Some literature discussing option selling strategies
and risk management can be found. [1] made a statistical
analysis of options in five markets – S&P 500 Index, Nasdaq
100 Index, Eurodollar, Japanese Yen and live cattle. The
author concludes that for both puts and calls traded in each
of these markets options expiring worthless outnumbered
those expiring in-the-money. [2] analyzed the benefits and
drawbacks of naked options, bull put/bear call spread and
calendar spread respectively. They propose managing risk
rather than limiting risk. [3] introduced some basic
knowledge about options selling like breakeven points. In
addition, he analyzed short naked puts and short strangle. [4]
compared three option selling strategies – short naked put,
protective call (bear call spread) and strangle. He suggests
not use delta-neutrality as risk management tool because
selling more options to maintain delta-neutral is not worth.
[5] discussed the benefits and issues associated with option
selling and compared the features of option trading and
future trading. [6] discussed influence of volatility changing
to option selling strategies and he suggests not use Sharp
Ratio as risk measurement. Instead, Value-at-Risk is an
alternative choice. [7] analyzed risks associated with option
selling. The authors discussed some risk management
methods – closing positions, double-up, covered call and the
roller. Finally, the authors suggest investors use credit
178
spread. [8] analyzed credit spread strategy. [9] suggested
selling options with the help from Fed. [10] examined
strangle and straddle strategies for options on Treasury Index
iShare. They used “delta-neutrality” as risk management
tool.
III. RISK PARAMETERS - GREEKS
In option trading world, Greeks are used to measure the
sensitivities of the value of a portfolio to a small change in a
given underlying parameter, so that component risks may be
treated in isolation, and the portfolio rebalanced (or hedged)
accordingly to achieve a desired exposure. These Greeks
derived from Black-Scholes model include Delta, Gamma,
Vega and Theta.
Delta of an option is defined as the rate of change of the
option price with respect to the price of the underlying asset.
It is the slope of the curve that relates the option price to the
underlying asset price. Option delta is represented as the
price change given a 1 point move in the underlying asset
and is usually displayed as a decimal value. Delta values
range between 0 and 1 for call options and -1 to 0 for put
options.
Gamma of an option is defined as the rate of change of
the option’s delta with respect to the price of the underlying
asset. If gamma is small, delta changes slowly, and
adjustments to keep a portfolio delta neutral need to be made
are relatively infrequent. However, if the absolute value of
gamma is large, delta is highly sensitive to the price of the
underlying asset. It is then quite risky to leave a delta-neutral
portfolio unchanged for any length of time. As the absolute
value of gamma increases, the sensitivity of the value of the
option portfolio to underlying price increases.
Vega of an option is defined as the rate of change of the
value of the option with respect to the volatility of the
underlying asset. Gamma neutrality protects against large
changes in the volatility of the underlying price.
Theta of an option is defined as the rate of change of the
value of the option respect to the passage of time with all
else remaining the same. Theta is sometimes referred to as
the time decay of the option. Usually, when theta is quoted,
time is measured in days, so that theta is the change in the
option value when 1 day passes with all else remaining the
same. When gamma is negative, theta tends to be positive
and the reverse is true.
IV. OPTION SELLING STRATEGIES
Options are a wasting asset. They will lose value as time
passes. Option sellers have positive theta, which means they
will collect the premium as time passes. Figure 1 shows how
the time decay of an option accelerates as it approaches
expiry.
 Figure 2. P&L Graph of Short Straddle Position at Expiry.

Figure 1. Time Remaining until Expiration Date.

All option selling strategies are designed to take

advantage of time decay, i.e. option selling strategies have V. EMPIRICAL RESULTS
positive theta. In the following, some commonly used option
selling strategies are discussed and a option selling strategy A. Data
is proposed. In order to test the performance of proposed strategy,
A. Typical Option Selling Strategies Hang Seng Index (HSI) option data is used. The data was
collected from Hang Kong Exchanges and Clearing Limited,
In Table 1, we show some typical option selling ranging from Jan 2006 to December 2010. It includes every
strategies and their corresponding risk characteristics when tick data of option bid-ask price. The HSI option is European
the position is set up. style i.e. it only can be exercised on the expiration day. To
ensure the success of every trade, the bid price is used as
TABLE I. TYPICAL OPTION SELLING STRATEGIES trade price when selling options.
Strategy Delta Gamma Vega Theta
High Moderate Moderate Moderate
B. Back-testing Results
Short Call
Negative Negative Negative Positive The proposed straddle strategy is tested using above HSI
High Moderate Moderate Moderate option data. In Table II, yearly returns of straddle strategy
Short Put
Positive Negative Negative Positive
Low High High High from 2006 to 2010 are listed and compared with HSI. In
Straddle/Strangle order to further confirm the performance of straddle strategy
Zero Negative Negative Positive
Low Moderate Moderate Moderate more measures are used, and the results are shown in Table
Condor/Butterfly
Zero Negative Negative Positive
Moderate Low Low Low
III. Figure 3 plots the returns of straddle and HSI.
Bull Put Spread
Positive Negative Negative Positive
Moderate Low Low Low TABLE II. RETURN COMPARISON
Bear Call Spread
Negative Negative Negative Positive Year Return of Straddle Return of HSI
2006 12.6% 34.2%
2007 32.6% 39.3%
B. Proposed Option Selling Strategy 2008 -21.9% -48.3%
2009 342.6% 52.0%
Although there are several different option selling 2010 78.1% 5.3%
strategies, we propose straddle as the strategy to be tested in Average 88.8% 16.5%
this research. As can be observed in Table 1, straddle has the
highest positive theta. In addition, it is a delta-neutral TABLE III. PERFORMANCE COMPARISON
strategy, i.e. it has no direction bias when the position is set
up. The strategy is described as follows and its P&L graph at Straddle HSI
expiry is shown in Figure 2: Yearly Compound Return 55.8% 9.1%
a) Sell one at-the-money call option and one at-the-
Average Monthly Return 5.2% 1.0%
money put option simultaneously at the beginning of
calendar month. Volatility of Monthly Return 16.9% 7.3%
b) Hold the position to maturity. Sharpe Ratio 1.41 0.46

179
 management into consideration. These two factors will be
included in future research.
[1]
[2]
[3]
Figure 3. Return Comparison from 2006 to 2010
[4]
As can be observed in Table 1, yearly average return
(88.8%) of straddle strategy greatly outperforms HSI [5]
(16.5%) during the period of 2006-2010. In Table 2, we can
[6]
see that straddle is also much better than HSI in terms of
yearly compound return and average monthly return. The
[7]
volatility of monthly return of straddle is worse than HSI in
terms of volatility. However, its sharp ratio (1.41) is much
better than HSI (0.46) due to its high return. [8]
From above comparisons, we find that option selling
strategies have great profit generating ability. The [9]
performance has been verified in this research. It can be used
as an new investment asset in the portfolio. Although the
[10] J. Cordier and M. Gross. Examination of long-term bond Ishare
back-testing results show that straddle greatly outperforms
HSI, we did not take risk management and capital
180
View publication stats
REFERENCES
J. F. Summa. Option Sellers vs Buyers: who wins? Futures, 2003,
32(4), pp. 52–55.
J. Cordier and M. Gross. Option Selling with Limited Risk. Futures,
2005, 34(9), pp. 52–68
T. Zurick. Setting the Stage for Option Selling. Futures, 2005, 34(1),
pp. 52–54.
T. Zurick. Option Selling: Getting Defensive. Futures, 2005, 34(4),
pp. 42–45.
T. Zurick. Option Selling: Getting Defensive. Futures, 2005, 34(5),
pp. 48–50.
D. P. Collins. Are option writers due for a fall? Futures, 2006, 35(7),
pp. 62–66.
T. Elenbaas and D. Tsou. Risk Management for Option Writers,
Futures, 2006, 35(12), pp. 22–24.
L. Lowell. Three dimensional trading. Futures, 2007, 36(9), 42–43.
J. Cordier and M. Gross. Collecting premium with help from the Fed.
Futures, 2008, 37(7), pp. 48–50.
option selling strategies. Journal of Futures Markets, 2010, 30(5), pp.
465–489.