Naturally, individuals are inclined to learn what the best and most profitable options trading strategies are based on historical data in order to emulate these investing tactics themselves.
The good news is that studies have been done on the different types of options strategies by looking at annualized returns over a period of time.
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Best Options Strategy?
Based on a study published in 2006, Doron and Fodor attempted to find the answer to this question by looking at data of twelve portfolios involving S&P 100/500 index options.
Each portfolio used different options based on maturities and their “moneyness” – a measure of where the option is relative to the current price of the underlying asset – that is, either in-the-money (ITM), out-of-the-money (OTM), or at-the-money (ATM).
Performance was also assessed by taking into account transaction costs, margin requirements, and bid-ask spreads. Performance was placed alongside a benchmark portfolio that was only long the underlying assets contained in the studied portfolio.
Which portfolios did best relative to the benchmark portfolios in terms of marginal impact would shed insight into how each type of option performed according to historical data.
The three factors were taken into account in terms of option characteristics:
1. Whether it was buy or sell
2. The moneyness of the option (e.g., ITM, OTM, ATM) and
3. And the direction of the option (e.g., call or put)
When forming a strategy, investors have four main parameters on which to go in terms of the four main buy/sell-call/put combinations:
Buying calls gives the investor the right to purchase stock.
Buying puts gives the investor the right to sell stock. Selling calls give the investor the obligation to sell stock. And selling puts gives the investor the obligation to buy stock.
The buying calls/selling puts and buying puts/selling calls strategies are inherently intertwined.
From there, the investor has to make the determination of what strike price to select.
The option will either be in-the-money (ITM), at-the-money (ATM), or out-of-the-money (OTM). Investors that are buying options will have to pay more in premium for an option that is ITM because it’s already in their favor.
Investors that are selling options will earn less in premium for writing an ITM option, as they hold less inherent risk and hence won’t be compensated as highly.
The authors’ results came as follows for three-month expiration times:
Selling ITM puts
Selling ITM puts was found to be the most effective overall options strategy based on the data accumulated with an annualized return of 11.1% based on the 10-year holding period.
This strategy involves selling options at a strike below the underlying price.
For example, if you were trading Coca-Cola (KO) and wanted to sell a put option at 42 while it’s currently trading at 41, this would represent selling an ITM option. A 42 put takes the position that price will expire below 42. Since it is currently below that price, it is considered ITM.
The nice thing with ITM puts is that of any of the moneyness options (i.e., ITM, ATM, OTM) within the put selling framework, ITM options provide the highest premium.
This makes logical sense given that investors who sell puts have an obligation to sell stock in the case of an options contract that finishes ITM. Hence the risk is highest and the compensation takes this into account accordingly.
The more ITM an option is, or the closer it is to being ITM, the higher the premium offered.
Why selling ITM puts is most effective makes sense given premiums are the highest and equity markets tend to go up over time (though, of course, this is no guarantee).
An ITM put mirrors being long the asset as long as it’s ITM, so a falling market would cause losses.
Selling ATM puts
Selling ATM puts was found the be the second-most effective strategy with a 10.5% annualized return from the 10-year period. Selling ATM puts entails writing options contracts for stocks that have a strike the same as the underlying price.
Continuing with the case of KO, if you wished to sell a 41 put while it was trading around the 41 whole number, this would represent an ATM option.
Selling OTM puts
Selling OTM puts came in third with a 9.3% annualized return from the 10-year period.
Selling OTM puts involves writing options contracts for stock with a strike less than the underlying.
If you sold a 40 put on KO while it was trading at 41, this would represent an OTM option given that the stock was currently trading above the strike price. The seller would have a strong chance of this working out, but due to the lower risk, would be forced to accept less premium as a result.
However, if one were to rank the effectiveness of selling puts based on moneyness (ITM, ATM, OTM), this would usually be reversed in the case of bear markets. When prices decrease in the market, selling OTM puts would outperform selling ITM puts on average.
Overall, selling puts was clearly the most effective strategy. This was followed by selling calls.
On the buy-side, given that buying calls is most associated with the selling puts strategy, buying calls beat out buying puts for third place based on buy/sell-moneyness classification. So overall, we see this type of percent-returns hierarchy based on the buy/sell-call/put criteria:
1. Selling puts
2. Selling calls
3. Buying calls
4. Buying puts
The authors, however, found different results based on the time horizon.
Over the long-run, buying calls is the most effective options strategy.
This makes rational sense given that of the four main aforementioned classifications, buying calls provides the most unlimited potential and suffers least from time decay.
Conclusion
The main takeaway points from the Doron and Fodor (2006) study demonstrate that selling puts is the best short-term options strategy, as measured over three- and six-month expiration times.
For 12-month or longer expirations, buying calls was the most effective, giving it the unofficial title as the best long-term options strategy.
Selling put options provides a great strategy for believing a stock will increase, but are willing to get into a stock at a lower price even if the option expires out of the money.
This makes logical sense given the premium involved. In bullish markets, selling puts of the ITM variety will tend to be the most profitable on average. Selling OTM puts will tend to be the most profitable in bearish markets.
However, over a longer time horizon of twelve months or more, buying calls is the best of the four main classifications due to their limitless potential and risk that is predefined by the premium paid alone.
