Option Selling Strategies: Common Mistakes and How to Avoid Them

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Market Leader continues publishing opinions of western technical analysis specialists and comments of analysts from the Masterforex-V Trading Academy.Today we are offering an article by James Cordier and Michael Gross, Option Selling Strategies: Common Mistakes and How to Avoid Them. James Cordier is a founder of Liberty Trading Group, an investment company exclusively specializing in commodities options selling.Michael Gross holds an analyst position at the same company.Aleksandr Komarskikh, Head of the Options Faculty of the Masterforex-V Trading Academy, offered his comments on this article.

In today’s volatile and unpredictable markets, option selling is becoming a popular choice among higher net worth traders and investors due to the high probabilities of success and the ability to perform in any kind of market conditions. Indeed, option selling can be a powerful way to diversify into a potentially high yielding investment. However, there is no free lunch. Strategies based on option selling are easy to understand but one can take ages to learn trading by the strategy. Option selling, especially in the commodities, has it’s own set of risks. Knowing how to deal with them should not only allay any fears you may have about selling premium, it can substantially boost your bottom line.

When considering whether or not to allocate capital to an option selling portfolio, first review all and any necessary information you can find on this subject matter.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.

It is my experience, however, that not doing the wrong things will have every bit if not more impact on your portfolio’s ultimate performance than doing all of the right things. So, one should learn a lot from other people’s mistakes. To this end, we will consider three gross mistakes made by option sellers and, most importantly, simple ways of avoiding them.

Mistake # 1: Overpositioning (extreme trading/positioning)

This is the most widespread and gross mistake made by beginning option traders. Most brokers for self directed traders would see investors do this time and again. No matter how intensively and for how long you school beginners on how to sell options but it’s tough to tell them how to position properly.

It usually looks like this:

Beginners sell a few options, see them decay, get excited thinking they’d found the holy grail of investments, and proceed to go crazy with selling far too many. They would end up with either too many options for their account or too concentrated on one or two sectors. This puts the whole portfolio at greater risk. Option selling works but you have to understand and respect the leverage. Remember that you have to make right trading decisions most of the time though you might get a losing trade from time to time. This loss should not devastate your capital and force you out of trading.

This also goes back to the trader vs. investor mentality. Option selling can sometimes be detrimental to active traders. Traders want to (in fact, they 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.

A few simple rules can help prevent over-exposure: keep 50% of your account capital in cash. Diversify your other 50% amongst at least 6-8 commodities, puts and calls, using a mix of naked and spread strategies. This is an investment portfolio structure based on many years of experience of managing a variety of funds. Use it and you won’t make the mistake of over-positioning. While the majority of professional fund managers that use option selling strategies in their trading, are focused on stock markets, the mercantile exchange offers a wider choice of traded instruments for diversification and benefiting more from wrong assessment of ‘premium levels’, in particular, from being seasonally ‘oversold/overbought’ which is quite typical of some agricultural markets.

Mistake # 2: Selling too close to the money (when the option is exercised at a price very close to the current market price)

Many option selling “experts” will tell you that the best way to sell options is to select strikes with less than 30 days remaining until expiration reasoning is that you get the maximum rate of time decay (see Figure). This approach may have its merits and looks good theoretically. But it has one major drawback: to get any premium in this strategy, you have to sell too close to the money.

Here’s a typical example of a trade:

The trader has the ultimate program for selling options. For three months he sold options in a variety of markets with about 30 days left until expiration. He did remarkably well. Next month, he was short Live Cattle calls and Soybean puts almost right at the money. Naturally, cattle prices might well jump, and soybean prices fall.  This may push both his positions into the money (when the call/put strike price is below/above the current market price of the underlying asset, i.e. more beneficial for the holder). If these are the only positions for this month, he is also violating rule #1 that can easily destroy the result of a few months’ profitable trading.

You avoid this mistake by selecting options that are at least 50% out of the money (i.e. 50% away from the market price) 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 4, 5 even 6 months out and still be taking profits in 60-90 days.

This 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 (unprofitable for buyers) is one key way you avoid taking a big loss.

Mistake # 3: Not Having an Exit Plan (a B plan)

While most investment books, courses, 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 yet, they panic and just react too sharply 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 rule for beginners in that it requires that if the value of the option you sold doubles as compared to the premium you got for it, close this losing position. Of course, sometimes such options expire at a price that will not be losing for the trade but here the risk isn’t justified.

It would be irresponsible to believe that one rule is suitable for each open position or optimal for all positions to be opened. Each trading situation is unique in a way 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 us, you better believe that we have an exit plan long before that option doubles. Managing risk on your option selling portfolio should be more like steering a large ship rather than steering a Formula 1 race car.

The point to take here is that there are several ways to manage your risk. Some option sellers use rigid stops, others exit the market gradually. The important thing is that you have some kind of exit plan in place. That way when your option reaches an unfavorable level, you know exactly what to do. You are not reacting emotionally.

Success is achieved through lack of failure

Option trading strategies based on selling may seem simple. But one shouldn’t delude themselves and be self-confident. Having the odds your was, which is what you actually do when selling options, doesn’t guarantee absence of price spikes in charts that ‘devastate’ positions of even the most experienced option sellers. The main task for a beginner is to try and not fail rather than show you’re better. If you avoid the three mistakes above you can stay in the game and hone your skills learning the subtleties of the markets you are trading in. This will help you walk a long way of becoming a professional option trader.

Aleksandr Komarskikh, Head of the Options Faculty of the Masterforex-V Trading Academy, offered his comments:

The authors touched upon a very interesting and topical issue of option selling.It is no secret that option selling or using option strategies based on option selling draws a lot of traders primarily due to the seemingly easy and simple money one can make.But, as the article properly points out option selling isn’t that simple.One should carefully study the options theory and essence to successfully trade them.Beginner option traders often fall for Mistake # 1.Each trader should be aware of their risk, calculate it and prevent any situation that can lead to an irreversible drawdown of the trading account.This is especially relevant for option selling.We all know that our risk is unlimited in such cases – and the crisis brought it out in full by literally ruining major stock market players (including banks) with a long history of success.This often resulted from an inadequate risk assessment.

A trading plan is also crucial (Mistake # 3). When opening any position (especially when selling options) the trader should have an action plan for different scenarios.This is what I call ‘maintaining a position’.All students of the MF Academy Options Faculty are perfectly aware of how crucial this aspect of option trading is and plan their actions well in advance,including cases when the market moves against the trader.One shouldn’t be afraid of this and simply know what to do in this scenario.Often, appropriate position maintenance can yield more profits than initially planned when it was being opened (by analogy with the article, Plan A).

In conclusion I would like to add that option sellers have recently been facing increased margin requirements from brokers for option selling (while we remember that selling was banned altogether on a number of trading floors during the spike of the crisis).In this context, the authors’ positive mood about the ‘markets being volatile and unpredictable’ seems a bit of mockery.However, one should remember that a professional can work under any conditions and this is where their advantage lies as compared to the wide market.

 

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