Power To The Elbow

Selling out-of-the-money (OTM) zero days to expiration (0DTE) puts on SPY can be a lucrative strategy for traders looking to capitalize on time decay. I view this strategy as betting that the market won’t collapse by the end of the day. However, it comes with significant risks, particularly due to market volatility and sudden price movements. Surprise announcements or even planned press conferences have historically made this strategy likened to picking up quarters in front of a steamroller. Essentially, you make a little bit of money until you get caught and then you’re dead. This article explores key strategies to mitigate these risks and avoid dying. This includes choosing the right strike price, using credit spreads, and managing liquidity effectively.

Choosing a Safe Strike Price: How Far OTM is Enough?

One of the most crucial aspects of selling 0DTE puts is selecting a strike price that offers a high probability of profit while minimizing risk. A common approach is to use delta as a proxy for probability. A delta between -0.10 and -0.20 generally indicates a strike price with an 80-90% probability of expiring worthless. This is an approximation that traders have adopted as a “rule of thumb” and isn’t actually what delta was originally intended to be used for.

Understanding Delta Calculation

Delta is a measure of how much an option’s price is expected to change based on a $1 move in the underlying asset. It is calculated using an options pricing model such as the Black-Scholes model, which factors in the current stock price, strike price, time to expiration, volatility, interest rates, and dividends. Delta ranges from 0 to -1 for puts and 0 to 1 for calls. A put option with a delta of -0.20 means that if SPY moves up $1, the put’s price is expected to decrease by $0.20, and vice versa. As expiration approaches, delta moves closer to either 0 or -1, depending on whether the option remains OTM or moves in-the-money (ITM).

Using Historic price changes to estimate risk

I like to look at how today compares to similar days in the past to understand what range I can anticipate the price to stay within. Past price movements are not reliable to make future investments, but I find that it is helpful to use it as a baseline to start my analisis. 

I have downloaded all the available historic price data for SPY from yahoo finance. I then see how often the price closes up or down a specific percentage based on how much the price has changed at open. I use some complex excel formulas to accomplish this and would genuinely love to chat about it with anyone who is interested. I then settle on a strike price that is sufficiently out of the money that historically would close out of the money at least 95% of the time based on how the SPY has opened. 

Other rules of thumb

If there are fed meetings or the President is scheduled to speak during the day, I tend to avoid trading on those days. Remember, the key to this strategy is to avoid dying. I don’t think it is worth exposing myself to known risks that might finish me off. 

A big hint that something might be brewing can be found by monitoring implied volatility (IV). IV can go up for many different reasons like big price changes the day before or a highly anticipated event that will likely cause future price movements. It is always a good idea to figure out why traders are willing to pay higher prices for options as higher IV environments may require selling further OTM to maintain the same level of safety.

There are many other ways to choose which strike price to sell. Often it is a balancing act between margin of safety and the price you get paid. On a percentage basis, traders selecting puts that are 1-2% OTM can find a reasonable equilibrium between premium collection and safety. This range is typically far enough away from the current SPY price to withstand normal daily fluctuations while still offering a meaningful premium. 

Using Credit Spreads to Reduce Risk

One way to limit the downside risk of selling naked puts is by turning the trade into a credit spread. This involves purchasing a further out-of-the-money put to cap potential losses.

Which Put to Buy?

When selling a put at a specific strike (e.g., 1.5% OTM), the protective put should typically be placed 2-5 strikes lower, depending on risk tolerance. A common spread width is 5 points for SPY options, though some traders opt for 3- or 10-point spreads based on capital constraints and market conditions.

For example, if SPY is trading at $500 and you sell the 495 put, you might buy the 490 put. This limits the maximum loss to the spread width (5 points or $500 per contract) minus the premium collected, reducing the potential for catastrophic losses in case of a sharp market decline.

Benefits of Credit Spreads

• Defined Risk: The spread structure ensures that your losses are capped.
• Lower Margin Requirements: Unlike naked put selling, credit spreads require significantly less margin.
• Higher Return on Risk: Since the risk is capped, the return on capital can be more attractive compared to naked put selling.

Liquidity Management: Avoiding Margin Calls

Proper liquidity management is essential when trading 0DTE options, especially when selling puts. Market swings can quickly lead to margin calls if liquidity is not properly managed.

Recommended Liquidity Levels

A good rule of thumb is to keep at least 30-50% of your portfolio in cash or highly liquid assets. This buffer allows traders to manage adverse price movements without being forced into liquidations at unfavorable prices.

Strategies to Mitigate Margin Call Risk

1. Position Sizing: Avoid overleveraging by ensuring that the total exposure of your short puts (or credit spreads) does not exceed a reasonable percentage of your account value. Keeping risk exposure to 5-10% per trade can prevent catastrophic losses.
2. Rolling the Position: If the trade moves against you, consider rolling the short put further out in time or to a lower strike to reduce risk while maintaining premium collection.
3. Using a Stop-Loss or Manual Exit Strategy: Setting a predefined loss threshold (e.g., 200% of premium collected) can help avoid large drawdowns.
4. Hedging with SPY Shares or Futures: In extreme conditions, using SPY shares or futures as a hedge can help neutralize directional exposure and reduce potential losses.

Conclusion

Selling 0DTE puts on SPY can be profitable, but without proper risk management, it can also lead to significant losses. By selecting strike prices wisely, utilizing credit spreads, and maintaining adequate liquidity, traders can reduce their exposure to sudden market downturns. A disciplined approach, combined with active monitoring and risk mitigation strategies, is key to sustaining long-term profitability in this high-risk, high-reward strategy.