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December 5, 2010 - by Christopher Smith
  

The Myth of Monthly Income Trading

Many Options Traders Seek Monthly Income Through The Sale of Option Premium
  
We have all heard the tales.  Selling option premium monthly to generate a steady return one month after the next.  At first we wonder whether it is possible, but our questioning mind is soothed with assurance that we will only use high probability, limited risk trades and that everything is going to be alright.

Besides, the math is with us.  We have a Nobel prize winning mathematical formula that we can use to determine which options are statistically unlikely to be in the money when expiration rolls around.  We can just sell those options and be reasonably certain that they will expire worthless... Right?

The concept behind monthly income trading is to use time decay as a surrogate for being right about short-term directional market moves.  If we can sell options and let their value decay as expiration grows near, then we can consistently generate a healthy monthly return.

When asking retail trades about their planned monthly returns I have heard anything and everything from 1 or 2 percentage points each month to generating returns adequate enough to allow them to trade full time and live off of the profits they generate from their $5,000 or $10,000 trading account.

It is time to inject some reality into this discussion...

Probabilities are not easily calculated because those calculations largely depend upon an accurate forecast of the underlying security's price over a specified period of time.  Market volatility changes, however.  As such, a probability calculation requires that we forecast a security's future volatility.

Sometimes our volatility forecast will be rather accurate and the probabilities that we calculate will be close enough that our choice of options will provide us with a high probability of succeeding.  Unexpected things happen in the market, however.  We will not always be able to foresee the unexpected and, therefore, we will not be able to factor those events into our volatility forecasts.

The truth is that success as a monthly income trader is not derived from the high probability nature of the option strategies used.  Success depends upon a solid understanding of how probabilities, standard deviations, and other statistical measures used for such trading are derived.  That understanding must also be coupled with sound risk management.

It is through the risk management that traders gain their edge against the market.  Most retail traders fail to remain profitable because they place too much confidence in the "myth" of monthly income trading and fail to apply the needed risk management principles.

While no trader can guarantee themselves a monthly profit, monthly income trading can be a viable trading approach if you first invest the time to fully understand the nature of the options that you are trading and then apply sound risk management principles designed to maintain profitability even in the most unforgiving of market environments.

 

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