Avoiding the “Big Hit” When Selling Options
The biggest fear of many new Option Sellers is having one big loss come along that saps months of hard earned profits. In this Special Feature Video, Michael Gross reveals the 4 common sense steps EVERY Option Seller should take to help insulate their portfolio from unexpected loss and pave the way for more consistent monthly returns.
Avoiding The Big Hit In Option Selling Michael Gross Video Lesson
Hi. This is Michael Gross co-author of “McGraw-Hill’s The Complete To Option Selling” and Director Of Research here at OptionSellers.com. I’m here with your bi-monthly video lesson. The topic of this week’s lesson is Avoiding The Big Hit. This is a great subject to talk about. Recently, we’ve seen some extreme volatility in the stock market. A lot of investors that I’ve spoken to over the last couple of months have expressed concern about those moves in the stock market and start thinking about big hits to their portfolio. So, they’re looking at other investments. They start looking at commodity option selling. One of the top questions is, “That sounds great but, how do I avoid that one big hit that comes along and takes all my profits from the last three months?” That’s always been the knock on option selling is, yes, it can be good, it can be great and then, one bad month and you’re all back to square one because you can lose it all in one shot. It doesn’t have to be that way. We’re going to talk about that. How you avoid those big hits and just keep your steady premium collection going. So, rather than having six steps forward and then one huge step back, we want to keep it going six steps forward, one step back, and then another six steps forward. That’s how build a consistently producing option selling portfolio.
Before we get started, I do want to mention if you would like to learn more risk management option selling or option selling in general, how to build a consistent option selling portfolio, I do recommend “The Complete Guide To Option Selling”. It’s just recently out in its new third edition. You can get it on our website at a 40% discount off the cover price. That’s OptionSellers.com\book. So let’s talk about avoiding the big hit. First of all, I want to talk about why it’s been on everyone’s mind more lately. This is why it’s been on everyone’s mind more lately. That’s my rendition of the stock market and the way it’s been moving. Depending on when you’re watching this, and we have rebounds, the point is we’ve had some extreme volatility as of late and, a lot of the people that watch these videos and subscribe to our newsletter, etc., they trade index options. They trade either stock options or index options. Trading index options is great. You can apply a lot of the same concepts as commodities but a lot of the guys that trade index options, that’s all they do. So, they only have one asset class in one market to trade. That’s great because you can sell puts all the way up and you’re making money and that can be a great strategy for three, six, twelve months – it’s the greatest thing in the world until this happens. Then what? You’re all in one market. All your option sales, and I don’t care if you’re trading the S&P, or you’re trading the Russell, even the Q’s, you’re really all in stocks. So, this is an undiversified type of portfolio and no matter how you’re trading the S&P, this is saying, “Well, yes, but I sell Calls.” Well, that’s great, but you’re still in one market. So, the thing goes screaming up, you’re going to lose in the Calls. It’s not a diversified portfolio. Great strategy. I don’t not recommend it as part of an overall investment plan but, if you have a lot your capital just riding in the S&P and selling S&P options, you have some exposure there.
So, what’s one way to avoid the big hit? Well, one way is to get diversified in your option selling. The one asset class to that with, the primary asset class you can do that with, if you’re already selling options in stocks or indexes, is of course in commodities. So, one way to avoid the big hit, you get diversified in the commodities. These are all preliminaries. I want to get to my main point here in just a second. So, you get diversified. You’re out of equities, something does blow up in equities, you’re over here in commodities, which move to the beat of their own drummer, for the most part.
Number two, you employ the FUDOM Method. For those of you who aren’t familiar with the FUDOM Method I suggest you go back to the video lessons portion of our website where we cover FUDOM, the method we recommend. It’s also in our materials if you requested any of our free booklets on-line, which I recommend you do if you want to learn about this. FUDOM is really the method and philosophy we recommend to sell options. What it is, is selling fundamental deep out-of-the-money options. So you’re basing your decisions on long-term fundamentals in commodities and then you’re just selling deep, deep out-of-the-money options away from those fundamentals – in the opposite direction. This isn’t a seminar on FUDOM but, it’s one of the ways you do avoid the big hit. You sell deep out, even if you get spikes in the market, your options aren’t going in the money. That’s why you use FUDOM.
Third way you avoid a big hit in selling options or commodity options: You use a premium-based risk management system. We found this to be the most efficient way to manage risk when selling options. You decide when you sell that option at what point you’re going to get out and, you’re basing that on the value of the premium. So, whether that premium doubles, doubles and a half, triples – It’s not so much where you set that point, it’s that you have it and, you follow it when it’s hit regardless of what’s going on in the markets. Maybe you just don’t like the market you in or, maybe you want to look at it, fine. You get out of the option first. Then you re-evaluate. If you want to roll it at that point, sell options further up, you certainly do that. These are all things we talk about in other videos, other lessons. It’s all part of avoiding the big hit.
Now we’re going to get to number four, which is what I really want to talk about today. Number four is diversifying your outright option positions in your portfolio. So, I’m going to cover a little bit more about this because this is important and it’s one of the biggest mistakes new option sellers make with commodities and, it goes hand-in-hand with keeping a big cash cushion, which we just talked about in a recent video. When you’re selling index options, you can’t do this. You can’t have a diversified option selling portfolio. You can certainly sell options on different sides and you can use different strategies but, your positions aren’t really that diversified from each other.
For those of you who have been following us for any period of time, you’ve seen this circle. This is the basis for what we feel is how a successful, long-term, producing asset of an option selling portfolio should be structured. Fifty percent is kept as cash. That’s cash cushion which we’ve discussed in a prior lesson. What we’re going to talk about today is what you do with this other fifty percent. In commodities, you can sell options over a wide array of uncorrelated markets. The strategy here is instead of having all your equity in one market like the S&P and the whole thing takes a dump and your portfolio gets blown up, which was a lot of option sellers are afraid of. That’s their primary fear is I’m going to get blown up. Well, you get blown up because of your over position. That’s why you get blown up. So, we always avoid being over-positioned by simply taking series of small positions that are spread across a wide variety of uncorrelated markets. In addition, you’re selling on both sides of those markets at different times, depending on the market. It may have a detrimental affect on your portfolio at all, in fact, it may be beneficial. So, rather than your stock option selling portfolio or where you have ten different stocks sold, and the market tanks, and now your whole portfolio is sunk, or having your S&P or your Russell and the whole index tanks – that’s great if you’re on the call side of it but, again, you’re not diversified. We’re taking a series of tiny positions. So, maybe you have calls in soybeans, you sold puts in crude oil, you sold both sides of the natural gas market, you have calls in orange juice, up here you have puts in coffee. Small positions. What that means is if something blows up in one of those markets, which by the way, somewhat less common in commodities than it is in equities because commodities are reacting supply/demand fundamentals, which tend to change more slowly than the moods of the general public in getting spooked by something that happens in Washington at the Fed, or happens overseas in Syria, Paris, or what have you. These are commodities that are based on their supply/demand core fundamentals. Let’s suppose that something does happen – there’s a blight and it wipes out the coffee crop. It’s a tiny portion of your overall portfolio because one, half your position’s money is in cash already and this position here is only encompassing a small position of your overall portfolio. So, yes, this will be a losing trade. It goes up, hits your risk parameter and you’re out but, it’s not blowing up your whole portfolio. In other words, you’re avoid the big hit. That’s the whole purpose of this, the whole purpose of the video. Remember this circle. You’ll see it often in our videos, in our printed material, is what we base our managed portfolios on.
I hope you’ve found that helpful. This has been an important lesson. I hope you got something out of it. For those of you who are interested in learning more about managed option selling portfolios with OptionSellers.com, we do provide a complimentary Investor Discovery Pack. You can get it on our website at www.OptionSellers.com\Discovery. It will tell you all about our accounts, portfolios, how you get started, and what you can expect.
I hope you find this week’s lesson helpful. We look forward to seeing you again in two weeks. This is Michael Gross of OptionSellers.com.