Wednesday, December 24, 2014

How many premiums are fair for short options?

As an option seller, I've been interested to know if the premiums I received for selling options are fair or not. However, there are so many factors that impact the premiums of sold options. To obtain a reasonable feeling of the fairness, I studied the TLT option spreads that I dealt with in the last few months. I used TLT short options of similar probability of success, same amount of capital requirement with the same width ($5) for the vertical spreads, and day to expiration around 56+/-7 days. In this way, I was able to reduce the number of variables for this comparison.
My goal is to receive 10% to 13% return on capital (premium$/width$5) for all ETF's that I trade. For the TLT options that meet my criteria, it means the premium should be above $0.50. Based on the above table, it looks to me the following conclusions are true for the options of similar probability and risks.

  • Put premiums are higher than call premiums under similar conditions
  • Premiums are higher when the short option bid and ask prices are narrower
  • Premiums are higher when open interests are larger
  • Premiums are higher when Delta differences between short and long strikes are larger
  • Premiums are higher when the IV differences (Skew) between short and long strikes are smaller
  • Premiums may not be higher with longer DTE in the analyzed range
  • Higher IV of the option does not guarantee higher premium

My biggest surprise is that the higher IV's do not always provide higher premium or ROC. In October  turbulent trading, I could obtain higher ROC as IV was much higher in those days. But now, the IV of TLT is still high and yet its option premiums offer less ROC. I found other more liquid options (i.e. IWM) offer reasonable ROC (>10%) at the same time. The only reason I could find so far was the lack of open interests in the options. So I would conclude the lack of option liquidity means lower ROC for option sellers and the middle option price of bid and ask may not be fair.

In general, I believe this is one way for option sellers to estimate the fairness of option premiums as they use options of similar parameters for the comparison.

1 comment:

  1. I appreciate your analysis and think it can help in some of my trades. I usually don't go out past 30 days because I want theta to do its work.