Option Selling: What Duration Is Optimal For Our System?

Updated: Dec 30, 2019

Introduction

Selling options requires the 3-pronged skill set of strike price selection (10-14 delta in our case), selecting good underlyings (low-volatility stocks, based on thoroughly analyzing the technical and fundamental conditions) and duration. Duration is essential as we have to determine what time to expiration is needed to realize a nice profit, while looking for options that are not sensitive to gamma. In other words, is there an optimal duration which allows for steadily growing profits with the least amount of volatility?


We prefer two-month options over one-month options as we then collect at least 50% of our initial credit, while maintaining a high probability of profit and a wide win area (width between the call and put strike). After being 30 days in the trade, we want to roll out and reset to a new two-month duration. Why 30 days? Because that's the point where holding onto an 11-delta strangle doesn't pay for us anymore. Who wants to allocate a sizable amount of money (i.e. margin) to an investment which isn't going to reward you as generously as it did before? Just roll out to a new option series and get more bang for buck instead.

Also, we want to sell premium on stocks that see elevated implied volatility. Over the course of the trade, short vega starts to decrease which means that if we see a collapse in IV, the shorter-term options will benefit little from that event. Likewise, if the implied volatility rank remains elevated at 30 DTE, our volatility edge is much smaller than it was at the very beginning. Also, the opposite is true: higher IV will impact longer-term options more than the shorter-term series. During the lifecycle of the trade, theta (time decay) becomes more important than the risk of a surging IV, as shown below. For example, if you collect $100 in positive daily theta, you're short Vega worth $600. At 30 DTE, your positive theta is $70, while your short Vega amounts to $200. So if IV goes up 1% at 60 DTE, you are very likely to lose $500; at 30 DTE, that figure stands at $130.

For an out-of-the-money option, time decay starts slowing noticeably at 40 DTE, while the Vega declines at the same steady pace. Considering an 11-delta OTM option with 60 DTE and an IV of 21%, your positive theta is going to be 30% lower at 30 DTE, but your short vega representing the risk of a climbing IV will have dropped by 68% by that time.

For a 24-delta OTM option, time decay actually increases by 20% during the first 30 days. But there's a tradeoff: your short vega will have decreased by 43%, considerably less than for an OTM-option.

Conclusion

Strike price selection (represented by delta) and duration make the entire 3-piece puzzle complete. As discussed extensively in previous articles, low-volatility stocks are excellent vehicles for option selling. We prefer the two-month options over one-month options for various reasons: 1) sufficient time decay, 2) enough bang for our buck (premium/margin requirements), 3) high probability of profit, 4) out-of-the-money options offer constant time decay, 5) being short vega when the IV rank is attractive, bears fruit for option sellers who utilize the two-month series.


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