Balancing Risk and Reward

We can, of course, aim for higher premiums. This is achieved in two primary ways:

1. Trading Riskier Stocks: Focusing on stocks with higher implied volatility.
2. Selling “Closer to the Money”: Selling options that are less “out-of-the-money” (OTM).

The second approach reduces our “margin of safety” (a term borrowed from value investing), increasing the likelihood of being assigned the stock. Getting assigned triggers taxes and transaction costs, which eat into profits, so we generally want to avoid it if the goal is purely premium collection.

Managing Assignment

One strategy to avoid assignment is to buy back the option before it expires. We might do this at a lower price to realise most of the profit early, or at a higher price to cut a loss.

However, a core principle remains: only write options on stocks you are comfortable owning at the strike price. We should always be happy to get assigned the underlying stock, which means focusing on quality companies with attractive characteristics.

Diversification also plays a key role. Writing options on different companies reduces the likelihood of all contracts ending “in-the-money” (ITM) simultaneously, leveraging the fact that stocks are not perfectly correlated. In reality, however, if markets start to correct, all options will probably get exercised at the worst possible time.

The Role of Leverage and Risk Management

Enter risk management. Overleveraging—writing options for a notional amount that far exceeds your available cash—is a recipe for trouble. A modest amount of leverage is acceptable (using other portfolio assets as collateral), but don’t overdo it.

My comfort zone is writing options for a notional value up to 20% more than the cash available.

• With our $84,000 cash example, this means we can manage up to $100,000 in total notional value ($84,000 * 1.2).

The Delta Metric

To judge the likelihood of an option ending up ITM, traders often look at the option’s delta (based on the Black-Scholes model). Delta can be interpreted as the probability of the option being exercised.

• A put option with a delta of -0.2 suggests a 1 in 5 chance of assignment.

Ideally, we want a low delta, though this means a lower premium. I find that a delta range of -0.1 to -0.2 offers the ideal balance of premium and safety.

There are plenty of considerations when trading options. I have studied Hull’s Options, futures, and other derivatives in depth at University. and I have read the work of Nassim Taleb. I am familiar with the math behind parametric and non-parametric option pricing and its limitations. To keep this blog accessible to a broader audience, I use a simple conservative framework.