Avoiding the Biggest Mistake New Option Sellers Make in Commodities
While jubilant for the present, the soaring stock market has many investors of means keeping a wary eye towards the future. Such times can often bring “traditional” investors to finally venturing outside the box of “buy and hold” in search of alternative investments.
Dipping your toe into the option selling stream, particularly commodities option selling, can be a good way to start enjoying the benefits of premium collecting and simultaneously get diversified from the stock market.
Investors used to more traditional investments such as stocks can make a few common mistakes when it comes to commodities.
However, commodities are a different ballgame from stocks. Beginners tend to make common mistakes that can end up costing them a “tuition” to learn the ropes of this new asset class.( See “The 3 Biggest Mistakes New Option Sellers Make” on our blog.)
The biggest of these mistake is, hands down, getting over-positioned in your option selling portfolio.
How it Happens
This mistake of the new option seller is most often the result of these 2 factors: 1. His glee at watching his first set, or first several sets of options expire and 2. His misunderstanding of the leverage in commodities.
It usually happens like this: Dave the new option seller starts out selling some options in a commodity – any commodity – but we’ll say he writes them in Coffee. A week later he writes some in Corn. A week later, he writes some in Silver. 60-90 days later, they are either worthless or nearly worthless (this is a common occurrence.)
If he were a stock trader, this would be called “fully invested.” But as a commodities option seller, he is called “over positioned.”
Dave has just realized some very large premiums off of his first few trades. Euphoria sets in. He thinks he’s found the holy grail of trading. In his next round of selling, Dave is less discriminating in is option selection. He starts selling many, many options, only seeing the “money in the bank” they represent.
Pretty soon, he has 90-95% of his capital working in the market. If he were a stock trader, this would be called “fully invested.” But as a commodities option seller, he is called “over positioned.”
Why it Happens
Why? Because commodities options use leverage. Leverage is what makes the high returns possible. Leverage is why you can sell an option and take a $700 premium a mile out of the money and only put up $1,000 in margin requirement. But leverage can be a double-edge sword and can cut the hands of an inexperienced wielder. New option sellers often make the mistake of taking too many positions, either in one market or in their overall account.
Leverage is why you can sell an option and take a $700 premium a mile out of the money and only put up $1,000 in margin requirement
Dave is making the mistake of trading his commodities option selling portfolio like a stock or stock option portfolio. He is not understanding the margin. In particular, he is not understanding that his margin requirement on each option can change – and in fact does, on nearly a daily basis.
Most of the time, these changes are small and based on the daily value of the option. However, should a substantial, sudden move occur in one of his markets, the change could absorb what is left of his remaining (either as a result of a loss on the option, an increased margin requirement, or both.)
The risk to him is a large drawdown in his account (as a result of too large of a position) or a margin call (less concerning but still a nuisance.)
How You Can Avoid It
Investors new to commodities gasp in fear at the term margin call. But margin calls can easily be erased simply by doing what Dave should have done in the first place – lightening up on his position size. A substantial loss cannot be as easily eliminated and could take months or more to recover.
Dave could have avoided both of these headaches by simply positioning his portfolio correctly and not becoming overzealous in his premium collection.
How would he accomplish this? By keeping individual position size small and keeping a big reserve cash cushion in your account. We recommend up to 50% cash in our client accounts. An option selling portfolio with many small but diversified positions that holds an adequate cash cushion for margin fluctuations is a set up for success.
By following this blueprint you’ll limit your portfolio exposure to any one or two individual trades. The cash cushion not only keeps you from over positioning, it will all but insure you’ll never even hear the term margin call.
The diagram below illustrates the ideal structure for a commodities option selling portfolio
Sample Portfolio Structure
$1 Million Portfolio
You don’t have to be an expert in option selling to make money at it. But there are a few main pitfalls that prevent many an aspiring option seller from making it past the first inning of their new venture.
Avoiding these few common mistakes can take you a long way towards becoming a long term, consistently profitable option seller.
Over-positioning is the first and biggest of these mistakes.
Setting out with the proper structure for your account is how you avoid it and put yourself on the path to consistent growth.