A properly planned and executed option selling strategy can provide steady gains in all kinds of market conditions. There are a variety of approaches with various degrees of complexity and risk; the strategy we utilize at K4 Capital Management could be categorized as “far out-of-the-money naked option selling”. Please note that the following examples represent our personal opinions and trading style, and to sell naked options, you should develop your own in-depth, working knowledge of the topic.
You may occasionally come across some “ground rules” for option selling, usually in a book with “dummies” in the title. The most common one goes something like this: Get out of the trade if you lose 5% (or 10%, etc). Rules like these will cause you to exit almost every trade you make with – surprise - a 5% loss. Think about it: if you sell an E-mini put 200 points out of the money, are you really going to worry about the ultimate success of that trade when the S&P drops twenty points the next day? If you answered “yes” to that question, option selling is not for you. So – rule #1: Develop your own rules.
To an option seller, excess margin capacity is like oxygen. The minute your margin requirement exceeds your account equity, you lose control of your destiny and face liquidation of your positions. So you need a reasonable way to determine how many contracts you can sell for a given account size. One way to do this is to start with the Initial Margin requirement for the underlying futures contract. To that, you can add a safety cushion; in the example below we add 20%. If you are new to option selling, you might want to add 200%. Just keep it in your comfort zone and don’t get greedy. Remember that when a trade moves against you, you will be squeezed from two directions: your account equity declines as the option value increases, and the margin requirement increases as the option gets closer to the money. Read up on SPAN to see how margin on futures options is determined. In addition, you have to be ready for margin increases by both the exchanges and your broker’s risk manager in times of high volatility. From our observations, the risk manager’s job is to panic at the worst possible moment and change the margin ground rules on you.
Avoid “one dimensional” thinking. You don’t have to trade only the S&P E-minis. You don’t have to trade at all if nothing looks good to you; just take the day off, the market will still be there tomorrow. We stick with indexes, currencies, and interest rates.
Trading Basics - The first thing we do when we are ready to make a trade is to evaluate our choices. There may be many possible trade candidates, but for illustration purposes here we will narrow the field to two: the mini Russell (TF) and the yen (6J).
We are interested in some basic parameters - margin requirement, time to expiration, current price of the underlying future, and volatility. The numbers we come up with are:
Margin
Current Price
Time
Volatility
TF
$5500
469
41
45
6J
$5000
109.42
27
18
You can see that the margin requirement is roughly the same, so the number of contracts sold will be similar on either the Russell or the yen. But the Russell option (TF) has a longer time until expiration, and has a much higher volatility number. Note that volatility is the wild card here; you can look in five different places and come up with five different numbers. Our advice: don’t underestimate volatility; be consistent in the way you calculate it; and consider that volatility could change dramatically during the course of your trade. What you are looking for is a fair comparison of the potential risks among various trades.
Note that our system includes discretionary and non-discretionary inputs, so there is no magic formula you can just plug numbers into and spit out option strikes. However, you will find, with a brief web search, a number of books and web sites that will provide the building blocks for designing your own system. In the long run – and please trust us on this point - you will be far more successful with a system that you build and understand from the inside out.
Now, back to the trade - In this case, our evaluation of the criteria above suggest we consider a put strike no closer than 310 on the Russell and a call strike no closer than 119 on the yen. Looking at the Market Maker’s current bid/ask spreads, we can probably get 26 ticks ($325) for the yen calls, and 1.4 ticks ($140) for the Russell puts. This one appears to be a no brainer – the yield on the yen calls is more than double that of the Russell, with a much shorter exposure time. While there are other factors to consider in choosing what to trade, we’ll go with the yen for this example.
The next decision is how many contracts to trade. The maximum number of contracts we would sell is determined by multiplying the initial margin for the underlying futures contract by a safety factor we choose based on market conditions. For this example we’ll add a 20% buffer, for a total margin requirement of $6,000 per contract. If we assume a $100K account, you can sell 16 yen calls (always round in the direction of greater safety). But you don’t want your entire account tied up with one trade. You want to keep some margin available in case another opportunity comes up before those yen expire, so you choose to sell only 10 contracts. Upon execution of the trade, you receive $3,250 for the options and reserved $60,000 of your account equity to cover them; you will note that initially the actual margin requirement for this trade is a small fraction of $60,000, but if the yen moves to 117 you’ll see a much different story.
The probabilities are with you – more than likely, all you have to do is watch and wait for those options to expire and you will make more than 5% on the $60,000 you allocated to this trade. But you don’t learn anything from successful trades, so let’s see what happens if things go the other way.
If the yen pushes into the “red zone” (see chart), you are in for some sleepless nights, so we would begin to take corrective action immediately. Here are some things to keep in mind:
Overnight trading sessions can be volatile, and may have little or no liquidity for options. Make your trades in the day session; don’t leave yourself at the mercy of those overnight sessions. You have a number or possible strategies at your disposal. Be familiar with all of them ahead of time, and again don’t get locked into one-dimensional thinking. You can mix and match repair strategies to give yourself the best outcome. Your choice of strategies will depend primarily on how close you are to expiration.
Our number one rule when taking corrective action is to preserve as much of your original trading principal as possible. Forget about trying to preserve any “profits”; if you have come to this point those profits are long gone and you simply want to survive to trade another day. So we will give up those 26 ticks received on the original trade in order to move to a safer fallback position.
Here are the primary tools available to you if your option trade gets into trouble. The starting point for all the following strategies is simply to buy some or all of the contracts back. We often use an incremental approach.
Calculate the premium you received for the original trade. In our example, the total premium was $3250 to sell 10 options. Let’s assume that the current price of the 119 call is 100 ticks, or $1250. Your first move is to buy back three of those options for $3750. Now you only have seven contracts to deal with, and you have only clipped $500 from your original principal.
See what you can get for selling March yen calls a couple of strikes higher, say 121. We’ll assume there are still two weeks left until March expiration and the 121’s are going for 65 ticks each. We would like for as many of those yen calls as possible to go away in March, so we spend $5,000 to buy four of those 119’s back. In order to offset that cost, we’ll sell six of the March 121 calls at 65 ticks. That puts $4,875 back in our pocket.
We still have three of those 119’s left to deal with. At this point you may want to let those ride another day or two and see if your luck changes. Or you might take a look at April yen calls and see that the 125’s are going for about 100 ticks. We do like to get our sleep at night, so we buy back the last three March 119’s and sell three April 125’s to make up the cash.
The result – despite a very unusual move by the yen, you have preserved a reasonable chance of keeping almost all your starting principal. In addition, you have significantly reduced your margin requirement so you are in a position to take further corrective action if needed.
Option selling is often described as a ‘zero sum’ game, and no doubt after the last few months some option sellers would be very happy to settle for that result. But we don’t know of any other trading strategy where the probability of each trade’s success is so high, or where you have so many potential corrective measures available should the markets move against you. Make no mistake: it is not an easy strategy to master, and mismanaging a trade can have dire consequences. But if you do your homework, take your time, and don’t get greedy, you might find that option selling suits you just fine.
