It is one of the first questions that arise when one considers selling options for income on a futures portfolio: How do I manage my risk?
It is an important question with many answers. We have addressed some strategies for managing risk in past articles. Many of those, however, were spread strategies. This column will focus on managing risk for those traders who prefer to sell naked options. But before we discuss risk management, we should first discuss why a trader might choose to sell naked to begin with.
There are many reasons an investor may wish to forego more conservative spreads in favor of selling naked options. For one, if a trader is correct in his market analysis and the market moves in his favor, one can profit more quickly from a naked position than one can profit in a credit spread. Secondly, to collect the same premium, a trader willing to sell naked can sell a strike further out of the money than can the spreader who wishes to cover his downside with a long option.
For instance, suppose in May, two traders wish to sell options in New York Mercantile Exchange (Nymex) silver. Both are bearish and expect prices to remain steady or decline. Trader A elects to sell a bear call (vertical) spread. His trade appears as follows:
Trader A:
Sells 1 December Silver 18.00 call @ 21 cents ($1,050 US)*
Buys 1 December Silver 20.00 call @ 12 cents ($600 US)
Net 9 cents ($450 US) maximum profit
Trader B:
Sells 1 December Silver 21.00 call @ 9 cents ($450 US).
Net 9 cents ($450 US) maximum profit
Trader A gets the benefit of having his position “covered.” In other words, if the market does not move lower but begins to trek higher, his 18.00 short call will begin to increase in value – not what the option seller wants. However, as he is also long a 20.00 call, it will also increase in value – although not as quickly as the 18.00 call. His profits on the 20.00 call will offset much of the loss on his 18.00 short call. Therefore, the market would need to make an extreme move for this trade to show more than a minimal loss. In addition, even in an adverse move, the trader has the luxury of holding his position, as losses are only accumulating minimally. If and when the market reverses back into the traders favor, he will have a much better chance of still being in his position and thus, in a good situation to profit. It is for this reason that many novice option sellers prefer to begin their option selling career by spreading. There is a large margin for error and covered spreads can be very forgiving. Call it option selling with training wheels.
Trader B does not have his position covered. If silver prices begin to move higher, his option’s value will most likely increase at a faster rate than the spreader’s trade. However, it will also decay faster if the market moves favorably. For while the spreaders long call will lend some protection in an adverse move, it will also hinder his profitability in a favorable move, at least in the short term. A favorable move for a naked seller can mean taking profits long before expiration thereby freeing up margin and the newly gained profit for re-investment elsewhere. The spreader will most likely be stuck in the trade through (or close to) expiration if he wishes to make any profit.
Selling the naked call vs. selling the credit spread (premiums on strikes are theoretical and provided for example purposes only)
To illustrate, let us suppose that silver begins a bear market the day after both traders have established positions. The naked 21.00 call will begin to lose its value – the seller immediately able to show a paper profit. Should the value fall to a desirable level – say 1 cent ($50), the seller can simply elect to buy it back and take a $400 profit – quickly. The spreader, however, is at two disadvantages. First, he is short the 18.00 call, not the 21.00. Being closer to the money, his call will hold more value than the 21.00 call. Though his 18.00 call will begin to decay with the downward move in futures, his 20.00 call, which he is long, will also begin to decay. Therefore, the spread between the two options will tend to remain somewhat constant until the option nears expiration – at least as long as the futures market remains steady to lower.
Nonetheless, many traders swear by covered spreads and will scoff at the notion of even considering the risks of writing naked calls (or puts) in the futures market.
However, in our opinion, traders who start out selling option spreads with any amount of success, will (and should) naturally gravitate towards the naked selling of options. Maybe not on every trade, but they will begin to incorporate the strategy in the right situations.
Why would they do this? Primarily because it would allow them to build their portfolios much more quickly, which could, in turn mean a much higher return at years end. This, however, is where the fear mongers would enter and do all in their power to dissuade the investor from selling naked options. But is the fear justified?
The answer is yes and no. Naked futures options do entail unlimited risk. But the risk is no more, and usually less than trading the actual futures contract itself – a proposition that many investors do not find nearly as daunting. We are always amused at futures traders who, after years or months of managing a futures portfolio are fearful of the risks of selling options. By trading the actual contracts, they are already accepting much more risk than they would have to in a short option portfolio. Therefore, the answer is yes, option selling entails theoretical unlimited risk and no, selling options is generally not as risky as the public perceives it to be, nor can it be considered as high a risk as trading outright contracts.
A naked option selling portfolio can be structured like any other portfolio – with an aggressive, moderate or conservative slant. We prefer to view option selling as a conservative approach to an aggressive investment vehicle (futures).
Done correctly, naked selling can provide considerable returns. In the previous example, let’s suppose the naked option seller sold his December COMEX Silver call at $450. His SPAN margin for this trade, as an educated estimate and for the example purpose of this article, would be approximately $900. That means a 50% ROI in six months, if the seller holds until expiration. The seller may also, however, choose to exit this trade at an earlier date if he deems the profit adequate. This could happen at any time prior to expiration should the seller’s desired profit point be attained. Remember, all silver prices have to do is remain below $21.00 for the option to expire worthless and the seller keep the premium.
On the other hand, if silver prices begin to rise causing the value of the option to increase, the seller may also choose to close the option prior to expiration – should he become uncomfortable with the position.
A good option seller does not allow a single trade to have a large impact on his portfolio. Done incorrectly or with lax risk management, the option sale can provide an undesirable drawdown. The rewards are good, the odds of success stacked in the sellers favor (approx 80% of options held through expiration will expire worthless). Remember that in an option-selling portfolio, the winners take care of themselves. It is how the losers are managed that will determine the ultimate results.
With that in mind, we share our guidelines for building a risk conscious option selling portfolio and a few tips for managing losing positions.
Guidelines for building a risk adverse option-selling portfolio
Know your fundamentals: Many self-proclaimed option gurus will dazzle you with gammas, betas and impressive looking formulas that look vaguely familiar to your calculus final in high school. Most of these are simply different ways of looking at volatility. Granted, volatility plays an important role in option trading (hint: you generally want to sell options with high volatility). However, many options traders will buy or sell an option based solely on volatility studies. We see this as trying to hit a baseball with one eye closed. Does anyone care to review what happened to the volatility players that sold crude oil calls into the rally last summer, simply because they were “overpriced?” Ask the volatility player who sold $65 crude calls what he thought of his volatility play when crude oil hit $79. It is our opinion that the importance of volatility is dwarfed by the core fundamentals that are driving the underlying contract. Volatility does not matter much to soybean prices if a drought in the US Midwest kills off half of the soybean crop. If this would happen, lower supply would drive prices higher – probably for a long time. And the market does not care what your volatility studies show. Your “expensive” call option would become more expensive. It’s important to know the volatility. It’s more important to know your fundamentals.
Diversify: This is a basic rule of investing that applies to option selling as well as any other investment vehicle. All of your eggs in one basket can mean a big payoff or a big blowup. It’s simply not worth the risk. Besides, there are option-selling opportunities in many markets. On the other hand, we advise not making the mistake of over diversifying. In other words, do not diversify simply to diversify. You should be looking for the best trade opportunities on the board. We typically advise our clients to be diversified in 3-5 different markets at any given time. In our experience, less than this can concentrate risk. More than this can dilute returns. (For more information on diversifying an option selling portfolio see Option Selling Strategy at www.libertytradinggroup.com )
Sell out of the money – Far out of the money: This is the key to successful option selling – in our opinion. Many new option sellers make the mistake of selling close to the money options in hopes of turning a quick profit. Option selling strategists teach that options experience their fastest time decay during their last 30 days before expiration. This is true. However, to capture any real premium in options – even futures options - with this little time remaining requires selling strikes dangerously close to the money. If you are right the market, profits can come quickly. But if you are wrong…
We prefer to sell options far out of the money with more time remaining and then be patient as they decay. Equity traders may be surprised to learn how far out of the money strikes are available in the futures arena. Our portfolios typically favor options that are at least 50% to 100% out of the money. By that, we mean the strike would be at a level more than 50-100% of the current value of the contract. For example, if we wished to sell a call in NYMEX natural gas, and gas futures were trading at $8.00 per MMBtu, we would look to sell a $16.00 call (100% out of the money). This would require natural gas prices to literally double in value before the option would ever go in the money. As this is unlikely, it reduces risk management to a premium based approach, rather than worrying what to do if your option goes in the money.
Natural gas prices would virtually have to double to reach the strike price
Do not, yes, DO NOT use stop loss orders on options: Stop loss orders can be a good idea when trading futures contracts. We advise against, however, using an actual open order stop in options trading. In options, the stop loss order is based on the premium of the option. Option values, depending on their liquidity, can be subjective in nature, sometimes making dips and jumps that seem “out of sync” with their underlying contracts. While these deviations generally correct themselves in a period of hours or days, they can wreak havoc on a trader with working stops in the market. Remember that a stop order becomes a market order as soon as the option trades at your stop price. For instance, suppose you are holding silver options that closed yesterday at 7 cents ($350). The market has jumped around quite a bit in the last several days but the option has only traded as high as 8 cents and as low as 6 cents. You are short 20 option contracts. You enter a stop order at 10 cents – feeling this should give the market plenty of room to move before you are stopped out. As you watch the day unfold, silver prices remain steady. Then unexpectedly, you watch a single silver option at your strike trade at 10 cents. On your option screen, you watch 20 more fill immediately after at 11 cents. 20 minutes later, your broker calls. You stopped out of all 20 of your option contracts at 11 cents. Later that day, you watch furiously as the same option settles at 7.5 cents.
What happened here? Most likely, a rogue bid or a market order came in to buy one option. Market orders are dangerous, especially in a less liquid option pit as a market maker can typically buy or sell it to the trader for a price of his choosing. In this case, the option filled at 10 cents, triggering your stop order for 20 options. This is virtually another market order then to buy 20 more of the options. The market maker (or another trader) then takes advantage again by selling them to you for 11 cents.
The other strikes around your strike do not exhibit such price moves however. At the end of the day, the option settles back “in line” with the other strikes.
Some traders argue that floor traders know where the stops are and can intentionally trigger stop orders by placing small market orders. While this is not supposed to happen, it theoretically could and therefore poses another risk to using stops on options. While the advent of electronic option trading could soon eliminate this possibility, it still cannot protect you from market orders triggering your stops into overpriced fills.
We never place open stop orders for our portfolios. Rather, we do enter stop alarms on our trading systems for when an option trades (or closes) at a predetermined exit point. Once these alarms are triggered, we work the orders as limit orders until filled. We recommend it as a good strategy for individual traders to follow as well.
If you would like more information about selling options in the commodities markets or building a portfolio based on the option selling approach, feel free to call or visit us on the web.
James Cordier and Michael Gross
Liberty Trading Group
401 East Jackson Street
Suite 2340
Tampa, FL 33602
(800) 346-1949
www.optionsellers.com
James Cordier and Michael Gross are portfolio managers with Liberty Trading Group, the first brokerage firm in the United States dedicated exclusively to option selling. They are also authors of the book “The Complete Guide to Option Selling” (McGraw-Hill 2005) and appear regularly on CNBC and Bloomberg Television. They can be reached through their website at www.optionsellers.com and work with an international client base. Free investor information packs are available at the website.
***The information in this article has been carefully compiled from sources believed to be reliable, but its accuracy is not guaranteed. Use it at your own risk. There is risk of loss in all trading. Past performance is not necessarily indicative of future results. Traders should read The Option Disclosure Statement before trading options and should understand the risks in option trading, including the fact that any time an option is sold, there is an unlimited risk of loss and when an option is purchased, the entire premium is at risk. In addition, any time an option is purchased or sold, transaction costs including brokerage and exchange fees are at risk. No representation is made that any account is likely to achieve profits or losses similar to those shown, or in any amount. An account may experience different results depending on factors such as timing of trades and account size. Before trading, one should be aware that with the potential for profits, there is also potential for losses, which may be very large. All opinions expressed are current opinions and are subject to change without notice.
