Options Trading Is Booming. 5 Rules for Investors.

Investor interest in option-selling strategies has grown so intense that some observers fret the activity threatens the stock market. The fear is that investors who sell put and call options, and the dealers who enable the trades, will create a giant wave of stock buying or selling, causing the system to buckle.

The fears might seem extreme, but it happened one day in February 2018— the so-called Volmageddon —when troubles with options volatility funds pushed the stock market down more than 1,000 points. At the same time, the Cboe Volatility Index or VIX, rose more than 100%, indicating investors were afraid of a severe stock market collapse.

Since then, interest in options has surged. Some market leaders think current daily trading volumes of about 40 million contracts could double in a few years. The rising prices of exchange stocks, including Cboe Global Markets, Nasdaq and Intercontinental Exchange reflect this.

Demand is intense. Goldman Sachs estimates that there are more than 250 funds dedicated to options trading, with assets under management exceeding $159 billion. The number of such funds, and the money earmarked to the strategies, is unique in the stock market’s history.

Moreover, many investors—ranging from individuals to traditional stock fund managers—now routinely sell options against stocks that they own, or want to buy. That activity likely dwarfs Goldman’s estimates. The risks this activity poses to increasingly interconnected stock and options markets could be significant.

What we do know is that in recent weeks—as the stock market rallied ever higher on expectations that the Federal Reserve will soon lower interest rates — Barron’s readers have increasingly asked how to manage options-selling strategies. That’s notable. They usually ask for feedback on market themes and trading ideas.

To help, we offer some strategy guardrails that will become important as aggressive interest in options continues to grow.

• Know your delta. Delta measures an option’s price sensitivity to stock-price movement. It also provides rough odds on trade success; “20 delta” options, for instance, have an 80% chance of profitably expiring if they are sold. Many investors sell “20 to 25 delta” options, which tend to be 5% to 10% above or below the stock’s price.

• Options are dynamic. Check them daily. Values dramatically change in real time. Have a plan to manage time, profits, and losses.

• Take profits. Conservative investors take profits when they have made 50% selling a call or put. Others exit at 70% or higher. The percentage doesn’t matter. The discipline does.

• Manage time. Rather than letting your options expire, “roll” them when you hit your profit percentage. If the options trade is failing, ideally wait until they expire on a Friday, or the day before, to adjust. This is risky. You could get assigned—meaning having to buy or sell the stock as a result. But you want the options’ time value to burn down so it is comprised mostly of the options’ proximity to the stock price. Many investors handle this by rolling out another week, or maybe another month, to collect more premium and to create time for the position to recover.

• Let it roll. Stocks will sink below put strikes, generating losses, or rise above the call strike to cap gains. So what. Options Yoda, a wise friend’s nickname, says in-the-money and out-of-the-money options—those with strike prices above or below, respectively, the stock’s current price—are the same. He’s content if he can get paid to roll options. Roll like Options Yoda.

Tradecraft is an encyclopedic, constantly evolving subject. Anyone who wants to successfully navigate the markets must continually refine how they handle risk and reward—especially those who use options to profit from the fear and greed of others.

—

Originally Posted September 4, 2024 – Options Trading Is Booming. 5 Rules for Investors.