In today’s volatile and unpredictable markets, option selling is becoming a popular choice among high net worth investors and traders. This has been mainly because of the strategy’s high probabilities of success on individual trades, ability to generate reliable income and positive performance in all types of market conditions.
But while option selling can be a powerful way to diversify into a non-correlated, non-directional strategy, there is no free lunch. Writing options is one of those strategies that is easy to understand but infinitely more difficult to master. Option selling, especially in commodities, has its own set of risks. Knowing how to deal with them should allay any fears you may have about selling premiums and boost your bottom line.
When considering whether or not to allocate capital to an option selling portfolio, many of the resources you may have access to describe a recommended way to go about selling options. Whether you hire a professional manager or attempt to go it alone, knowing what to do seems to take precedence over what not to do.
Experience shows, however, that not doing the wrong things will have as much, if not more, an impact on your portfolio’s ultimate performance than doing all of the right things. Therefore, we can learn a lot from the errors of others. To that end, we’ll explore the three biggest mistakes that option sellers make and, more importantly, discuss simple ways to avoid making them.
Mistake one: Over-positioning
Over-positioning is the biggest mistake new option sellers make. Most brokers servicing self-directed clients will see this again and again. No matter how much you school them on how to sell options, it is difficult to teach somebody how to position.
Typically, this is how it works: New traders sell a few options, see them decay and get excited thinking they have found the Holy Grail of investments. They proceed to ramp their activity to ridiculous levels, selling far too many options relative to their account size and end up with either too many options for their account or too concentrated in a particular market or sector. This puts the whole portfolio at greater risk of taking losses. Option selling works but you have to understand and respect the leverage. Remember you are supposed to be right most of the time in premium selling but at some point you will take a loss and you can’t let that loss wipe you out.
This also goes back to the trader versus investor mentality. Option selling can sometimes be detrimental to active traders. Traders want to (and sometimes think they have to) trade every day. Option selling is more of a passive activity that requires mostly time and patience. This puts the strategy at odds with active traders that like a lot of action.
Some simple guidelines can go a long way toward protecting against over-leverage: Keep 50% of your account capital in cash and diversify your other 50% among at least six to eight commodities, puts and calls using a mix of naked and spread strategies. This portfolio structure is based on many years of experience managing propriety and client funds. Use it and you won’t make the mistake of over-positioning. While the vast majority of professional option writing managers concentrate on stock index markets, diversifying across commodities provides more variety and allows you to better take advantage of mispriced premium levels, particularly some seasonal mispricing that often occurs in certain agricultural markets.
Mistake two: Selling too close to the money
Many option selling proponents will tell you that the best way to sell options is to select strikes with fewer than 30 days remaining until expiration. The reasoning is that you get the maximum rate of time decay (see “Premium decay,” right). This approach may have its merits, and it certainly looks good on paper, but it has one major drawback: To get any premium at all with this strategy, you have to sell quite close to the money. In the futures market, this can mean selling perilously close.
A typical experience goes like this: A trader will swear he has the ultimate program for selling options. For several months he will sell options in a variety of markets with about 30 days left until expiration and do remarkably well. The next month, let’s say he is short live cattle calls and soybean puts almost right at the money. It is certainly not unheard of for cattle prices to jump while soybeans fall. Such a scenario could put both positions in the money. If those were the only options he has that month, meaning he was also making mistake number one, it could easily wipe out months of steady profits.
Avoiding this mistake is simple. Just select options that are at least 50% out of the money and preferably 75% to 100% out of the money. This means looking for markets with a little more volatility and being willing to write them further out in time. Remember that you can sell options four, five or even six months out and still take profits in 60-90 days.
This guideline places your strikes far away from the market and sharply reduces the possibility of any of your options ever going in the money. In-the-money options appreciate quickly. Staying out of the money is one key way you avoid taking a big loss.
Mistake three: No exit plan
While most all investment books, courses and articles talk about risk management, you would be surprised to learn how many traders just wing it. They get excited about entering a trade and don’t bother to think about what they will do if things don’t go as planned. When they do get a trade that isn’t working, they can often experience altered judgment or, worse, panic and overreact regardless of where the market is.
Option selling is different than other investments in that it is difficult to draw a line in the sand and say, “if it gets here, I’m out.” That being said, the 200% rule is a good one for beginners. Basically, if the option sold doubles in value from the point at which you sold it, get out. True, there are times these options will ultimately expire worthless, but it is simply not worth the risk.
Of course, it is irresponsible to assume one rule is right for every position or that it is optimal for all positions to be placed with a pre-defined strategy beforehand. The variables with a short option make each situation different and it is difficult to make an exit plan when you don’t know what the scenario will be. However, if a position is moving against you, you should be prepared for action long before that option doubles in value. Usually this involves some form of scaling back and reducing exposure, allowing you to gradually adjust your position. Managing risk on your option selling portfolio should be more like steering a large ship than a Formula One race car.
The point is there are several ways to manage your risk. Some writers use hard stops while others roll out positions to further out strikes and contracts. The important thing is that you have an exit plan in place. That way, when the market or your option reaches a certain level, you know exactly what to do. You are not reacting emotionally.
Succeed by not failing
Option writing is a strategy that can seem easy. Don’t be fooled or become over confident. Putting the odds in your favor -- which is what you are doing when writing options -- does not protect from the spikes in volatility that often wipe out even experienced option writers. For beginning traders, whether you are selling commodity, equity index or equity options, the first step isn’t to excel. The first step is to not fail. Avoiding these three mistakes will keep you in the game as you hone your option selling skills and learn the intricacies of the markets you trade. It will take you a long way toward becoming an effective option seller for years to come.
James Cordier is the founder of Liberty Trading Group/OptionSellers.com, an investment firm specializing exclusively in selling commodities options. Michael Gross is an analyst with Liberty Trading Group/OptionSellers.com. Their website is www.OptionSellers.com.
For more from Cordier and Gross, click here.