I hope last week’s Part 1 blogpost led you to want to learn more about the Ultima Income Generator. If you missed it, you can click here to review the origin story of Ultima.
Now that we understand the name and the person that developed it, let’s talk about selling options.
Everyone Loves High Probability Selling
Yes, that title is true. Everyone loves selling until they don’t.
What do I mean by that? Well, they love it until they realize there are risks associated with selling way out-of-the-money options. You’ve probably heard the horror stories of people losing a lot of money. Unfortunately, those “stories” don’t provide enough insight into the strategy to do the cost/benefit analysis.
There are several mistakes that people make and hopefully you’ll be able to learn the right way to approach option selling.
Ultima Buy Low & Sell High
There is a concept that shouldn’t be foreign to traders that is central to the Ultima strategy. The idea is to buy high and sell low. That tends to be pretty intuitive when we’re talking stocks, but there is a tendency to get lost when people trade options.
I don’t mean that people struggle with the idea of buying for a lower price and selling for a higher price. Although, many have trouble realizing that possibility in their trading. I’m talking about implied volatility. That means that you always buy the option that has lower implied volatility and sell the option that has higher implied volatility. I don’t have time to expound on the concept of implied volatility here, but suffice it to say, this is a point of tremendous importance.
In the image below I have a chart of CBOE Volatility Index (VIX) Futures by expiration. The prices generally reflect those for the accompanying expiration. As you move from left to right, which one would you buy and which one would you sell?
I hope you would answer that you would buy FEB 22 and sell SEP 22. While this exercise doesn’t teach you how to trade Ultima, it does help you understand two things about index options.
- The higher priced options are typically further from expiration
- Selling more time brings in more premium
Conclusion
There are other considerations to make regarding the expiration to sell and we’ll get to them as we continue to discuss Ultima in additional daily posts. The first step in this process is understanding the buy high and sell low approach and applying it to the term structure of index option implied volatility, which we covered today. Before we’re done, we’ll cover implied volatility skew, theta decay and other factors as we narrow in on the Ultima Income Generator guide to trading.
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