One of the first concerns that arise when trading options for income on a futures portfolio is how to manage the risk.
Many strategies are available, and most of those involve spread strategies. However, there are benefits to selling naked options — that is, not off-setting them by creating spreads — and traders need to be aware of risk-mitigating techniques that specifically benefit naked positions.
There are many reasons to forego more conservative spreads in favor of naked positions. For one, if a trader is correct in his market analysis and the market moves in his favor, you profit more quickly from a naked position than a credit spread. Second, to collect the same premium, a trader willing to sell naked can sell a strike further out-of-the-money than a spread trader covering 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” sells a bear call (vertical) spread. His trade is as follows:
• Sell: 1 December Silver 18.00 call @ 21¢ ($1,050 US)
• Buy: 1 December Silver 20.00 call @ 12¢ ($600 US)
• Net: 9¢ ($450 US) maximum profit
Trader “A” has 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, he is also long a 20.00 call, and this will increase in value, although not as quickly as the 18.00 call that he is short. His profits on the 20.00 call will offset much of the loss on his 18.00 short call.
The risk benefits are pretty clear. 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 trader’s 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 forgiving.
Now, here’s Trader “B’s” position:
• Sell: 1 December Silver 21.00 call @ 9¢ ($450 US).
• Net: 9¢ ($450 US) maximum profit
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 Trader “A’s” position. However, it will also decay faster. Trader “A’s” long call will lend some protection to the short call in an adverse move, but it will also hinder profitability in a favorable move, at least in the short term. On the contrary, 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 likely will be stuck in the trade through, or close to, expiration to bank any profit.
As an illustration, suppose that silver begins a bear market the day after both traders have established their positions. The naked 21.00 call will begin to lose its value and the seller immediately shows a paper profit. Should the value fall to a desirable level, say, to 1¢, the seller can simply elect to buy it back and take a quick $400 profit.
The spreader, however, is at two disadvantages. First, he is short the 18.00 call, not the 21.00. Being closer-to-the-money, the call he sold short will retain more of its earlier 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, also will 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.
Despite some advantages, many trades don’t even consider selling naked options on futures. Perhaps this isn’t the best strategy for every trader, but it certainly isn’t logical to discard naked option selling outright. At the root of this belief isn’t logic, but an unfounded fear that naked option selling is too risky to even consider.
RISK CONTROL
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. Many traders think nothing of trading an outright futures contract but cringe at the thought of selling a naked option. Yes, option selling entails theoretical unlimited risk, but it is generally not as risky as the public perceives it to be.
A naked option selling portfolio can be structured like any other portfolio, with an aggressive, moderate or conservative slant. And, done correctly, naked selling can provide considerable returns.
In the earlier example, suppose the naked option seller sold his December silver call at $450. His margin for this trade (as an educated estimate and for example purposes only), would be about $900. That means a 50% rate of investment in six months, assuming the seller holds until expiration.
The seller may also exit this trade at an earlier date, which could happen at any time prior to expiration. All silver prices have to do is remain below $21.00 for the option to expire worthless and the seller to 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 close the option prior to expiration.
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 end in a large drawdown. The rewards are good, with the odds of success stacked in the sellers favor. (About 80% of options held through expiration will expire worthless.)
In an option-selling portfolio, the winners take care of themselves.
It is how the losers are managed that will determine the ultimate results. (“Guidelines,” page 47, describes ways to build a risk-conscious option selling portfolio.)
The futures options market makes it possible to sell options far out of the money — distances that simply aren’t available to equity options traders.
You can often find opportunities that favor options that are at least 50% to 100% out-of-the-money. In other words, the strike is at a level more than 50% to 100% of the current value of the underlying contract. For example, if Nymex natural gas futures were trading at $8.00 per mBtu, you could conceivably sell a $16.00 call (100% out-of-the-money). Because such a move is unlikely, although possible, it reduces risk management to a premium-based approach, rather than worrying what to do if your option goes in-the-money (see “Way up there,” above).
Another key to managing your option selling risk is not to use stop-loss orders. Stop loss orders can be a good idea when trading futures contracts, but 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 they make dips and jumps in price that seem out-of-sync with their underlying contracts. While these deviations generally correct themselves quickly, they can wreak havoc on working stops in the market.
This should be even clearer if you recall that a stop order becomes a market order as soon as the option trades at the stop price. For instance, suppose you are holding silver options that closed the day before at 7¢ ($350). Say that the market subsequently jumped around quite a bit, but the option only traded as high as 8¢ and as low as 6¢. You are short 20 option contracts. You enter a stop order at 10¢, thinking you are giving the market room to move. As the day unfolds, silver prices remain steady. Then, unexpectedly, one silver option at your strike trades at 10¢. On your option screen, you watch 20 more fill immediately after at 11¢. Your broker calls 20 minutes later: You stopped out of all 20 of your option contracts at 11¢. Later that day, you watch furiously as the same option settles at 7.5¢.
What most likely happened is 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¢, triggering your stop order for 20 options. This turns your order into a market order and the market maker (or another trader) takes advantage again by selling them to you for 11¢. 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.
Trading options has unique risks, and this is particularly true for selling options naked. However, the benefits of these positions are also unique. That means that for all traders, who should always be looking for trading opportunities that aren’t readily available elsewhere, carefully placed and managed short option positions make sense.
James Cordier and Michael Gross are portfolio managers with Liberty Trading Group, a brokerage firm that deals exclusively to option selling. They are also authors of the book The Complete Guide to Option Selling (McGraw-Hill 2005). They can be reached through their Web site at www.optionsellers.com.