Premium Sellers: Beware of widow makers

There are two different schools of thought on naked option selling programs. One view is that premium sellers are at an advantage as more than 80% of all options expire worthless. The other and perhaps more popular opinion is that one would have to be crazy to sell naked options, especially in the commodity markets.

While admittedly I may be a little biased since I operate my own premium selling program, Side Op LLC, I agree with the first opinion, but can certainly understand how selling options can seem daunting at first.

Naked option selling refers to the practice of selling options without having a position in the underlying instrument. For example, selling a call option that is based on corn prices without also owning corn (or a long futures position in corn) would be considered a naked short options trade. Short options trades, especially naked ones, are considered high risk because they have limited profit potential but unlimited risk.

For example, in selling corn puts, the profit potential is limited to the premium paid by the buyer of the option even if the option, at expiration, is out-of-the-money. But because the risk involved in selling options is unlimited, option writers are fully exposed to any adverse price movements and subject to margin calls. To use the example of selling corn puts, an at-the-money short put would lose $1.00 if the price of corn dropped $1.00 at expiration.

In light of these unique profit/loss characteristics, experienced traders understand that the key to successful short options trading – and, yes, that’s possible - is prudent risk management. While nearly anyone can catch a streak of good luck in selling options for a while and make money, the only way of separating successful trading programs in this space from the lucky ones that don’t last is to study the way they handle positions that move against them. With my own CTA, Side Op LLC, while my options strategy is 100% discretionary, my risk management is not.

No matter the circumstance options are liquidated or rolled away from the market as soon as they have moved 300% against me. While this rule may seem simple, it is hard to overstate its importance in managing risk in a disciplined way. By sticking to this rule, drawdowns can be managed.

Another important  risk management rule is to avoid certain markets altogether. It seems that there is a hundred year flood every month or so in the commodities markets, moving in one direction only for reasons that are not entirely obvious. While in futures trading, it is not wise to try and pick a top or a bottom, it’s a slightly different story when it comes to selling options. Premium sellers fade extreme trends by selling far out–of-the-money calls or puts after a sharp rally or decline. 

It is like selling insurance after the hurricane. This certainly is easier said than done since fundamentals (floods, droughts, surprise rate cuts, geopolitical risk, including turmoil in the Middle East) can drastically change the price trajectory of a specific commodity. Sitting in front of a quote screen from Monday to Friday almost every day since 1997 as an execution broker has taught me to avoid certain markets after certain directional moves. It also allows me to react quickly to price changes, and has taught me an unemotional and disciplined way of managing risk. A few of these "crazy" markets came to life this February.

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