Fixing A Broken Option Sale
3 Ways to “Rescue” an Option Sale that is Moving Against You
Hi, this is Michael Gross of OptionSellers.com here with your bi-monthly option seller video seminar. The title of this week’s seminar is “Fixing” a Broken Option Sale. This is a question we get here in the office often, somebody read the book or read some of our materials and they’re looking to sell options, maybe they look into starting out with it, and they have their first trade that goes against them. The common question we get is, “Hey James, hey Michael, I did this trade. It’s going against me. What should I do? How do I fix the trade?” That’s a good question. The wording in that is interesting because the primary system we recommend and still would recommend to you if you’re not working with a professional, you’re doing this on your own, we recommend using the 200% rule, which says you don’t try and fix it, it the thing doubles you get out of it, you re-assess, you move into other markets that are working.
That being said, do we always use the 200% rule when we’re managing portfolios? No we don’t, but we’re managing portfolios all day long so it’s what we’re focusing every minute of the day on. You at home, if you’re for a low maintenance type of portfolio and you have a career or a business or you’re just retired and you have other things to do, you don’t have time to be sitting in front of your screen 8 hours a day employing more sophisticated techniques. The 200% rule works just fine, as we said before, it’ll keep you out of trouble. That being said, if you’re looking for some more sophisticated techniques for managing risk we’re going to talk about those today. Now, implemented properly, can these take a few of the trades that you are losing and turn them into winners? Sure it can. They are a little more labor intensive, however, and that’s a trade-off you have to consider.
Let’s talk about some of these more advanced techniques today. First, I want to talk about if you are going to use a more advanced risk management technique, you want to think about what the purpose of it is. Obviously, the purpose of it is to save a losing trade, but the tactical purpose of it really is just to slow the market down enough to still give your trade time to work. That’s really what we’re trying to do here with these more sophisticated risk management tactics. That’s simply because, as you know as an option seller, time is always on your side. Everything you can do to keep that option in the game, every day that goes by is benefitting you. You just want to run out the clock on those. You could probably think about that in a football analogy. You’re up by 3 points and the other team is driving, your goal there is to run out the clock. It’s the same with an option that’s maybe moving against you. So, let’s get into some of these techniques.
Tactic 1 is what’s called the roll. You’ve seen us feature this before, we talk about it in our book. Rolling can be a very effective risk management technique. What rolling is, well, it more or less works like this. We’re going to use selling calls as an example here, but this can just as easily be applied to selling puts. So, here’s our price chart and you’re in the gold market. You sold a call because you think the price of gold is going to be steady or potentially move lower. So, you sold a call hoping it expires. Gold is kept moving up. Now, the value of your gold option has gone, let’s say you collected a premium of $800 when you sold it, and now it has reached $1,600. Uh-oh… it has doubled. Now, if you’re using the basic risk management technique, you’re just exiting at this point and you’re taking an $800 loss, moving on to greener pastures. If you want to try and fix the trade or use a more sophisticated technique, you can employ the roll. What that does is you’re going to go ahead and close this out at the $1,600 level and you’re going to roll it up here to 2 options that total close to $1,600. So, you’re going to recapture your initial premium and you’re also going to recapture your loss. Now, this trade will be successful if gold either levels off here or maybe it just keeps going up slowly but it doesn’t spike. What it really does is buy you some time.
As we talked about, that’s the purpose of a more sophisticated risk management technique. Rolling works when the fundamentals in your estimate have not changed. Rolling might work if the fundamentals haven’t changed, or something short-term is driving prices, maybe there’s a news story or something that come out that you don’t feel really has a long-term impact on price, it’s just speculators may be getting in off the news story. This is a classic weather markets in the summer, grain markets, are often candidates for rolls because you’ll have the grain fundamentals, which should ultimately determine direction of price, but during the summer often times even a couple days of warm weather and the news story comes out and says, “Oh, it’s too hot. It’s too cold. It’s too wet. It’s too dry.” It can bring buying to move the market one way or the other, possibly short-term against the fundamentals. Rolling can be very effective in these situations. If the fundamentals have changed, for instance, in late 2016 we had crude oil markets where they’re typically heading to the lowest point of the year in December/January had a big spike because OPEC came out and announced that they were implementing production cuts. That’s a change in fundamentals. SO, a fundamental change you’d want to use a different tactic.
With a fundamental change it’s called an opposite roll. So, you’re not rolling in the same direction, you’re actually reversing direction and rolling into the opposite. Let’s do this… here’s your gold option again, same market. The market is going up, up, up, the option doubles to $1,600. It’s doubling, you think it’s going to keep going because there’s been a substantial shift in the fundamentals of gold. The Fed did something, something happened in stocks, everybody’s piling to gold now, something geo-political happened, who knows, but the fundamentals have changed. Do you want to roll up now? Not if you think the price is going to keep going up, no. Instead, you’d want to roll down. So, you’d close out your option, $1,600, and then you’d roll down into puts, you’re selling puts probably 2 maybe sometimes even 3 puts to recapture the premium up here.
Now, when we talk about selling options, one of the main benefits of selling options is you’re not trying to predict what price is going to do. When you get into this, you are getting into that a little bit. You’re trying to out-guess the market but you’re still selling options. You’re not necessarily guessing that the market’s going to keep going up, you’re just guessing that it’s not going to crash in this scenario. The fundamentals have shifted enough. You think this is protected. That’s why you’re selling the puts at this level. Roll opposite is what you do when the fundamentals change. That’s the second risk management technique you can use.
The third one is a little more advanced. Here’s your gold chart again. You sold your call option up here. It’s doubled… it’s at $1,600. Now, I’m going to alter this a little bit. This is a good trade for this scenario. You just got into the trade, gold hasn’t moved substantially toward your strike price but right after you got into the trade, for whatever reason, you got a spike here and a spike here in volatility. It’s nowhere near your strike but the volatility is pushing up enough where your option value has increased. Now, you’d still like to hold this, you’re just dying, you don’t want to get out at $1,600. You still think this is going to expire worthless, no way it’s going to get there. Here’s a tactic you can use. Now, this is a little more aggressive. You’re down here, you turn it into a strangle, so you sell a put down below the market. Say you sell it for just the loss you’re taking right now on this, the $800. A little more aggressive, you can sell it for the full $1,600, so you’re balanced on both sides. Let’s just say you’re waiting into it. You sell it for $800. Now you effectively have a strangle on this market. What does that do? That buys you time on this option. So, if gold prices keep going up, now it can go up about another $800 and you’re going to be covered because your put is losing value. Now, it’s not going to lose it dollar for dollar but at the end of the day if it’s way up here this put will expire worthless.
What it does is gives you a hedge. It hedged, it allows the market to keep going up, if it starts going down the put will gain value, yes, but you’re going to be getting back your loss on the $1,600. So, you’re really turning this into a strangle. This is a more advanced technique. It can be a very effective technique, but it’s going to take some hands-on management. This is a position that has to be actively managed and, as we talked about at the beginning of the video, if you’d rather be out on the golf course or somewhere else then you’re probably going to want to stick to just the straight 200% rule and putting stops in and that type of thing. That being said, the roll strangle can be very effective in managing a position on this type of market. Those are the three more advanced techniques you can use if you’d like to get a little more advanced with your risk management.
One more thing I did want to mention is if you are managing a substantial portfolio, and we usually talk about portfolios of $1 million and up, you’re managing this as a serious investment. You’re not going to have one gold call on, you might have fifty gold calls on, you might have a hundred gold calls on. No matter what risk management tactic you’re using, whether you’re using the 200% rule, whether you’re using one of these tactics, you don’t have to do your position all at once. We talk about buying time here, so how you do that is you can leg out of your position. So, maybe it hits $1,600 and you get out of 25% of your position or 50% of your position and the other half you do something like this… that’s how you can do it. We don’t recommend an all or nothing type risk management approach when you’re working with a larger account with larger positions. You have the flexibility in a larger account to do things gradually, to leg in and out of positions, that is an advantage to having a larger account. It can mean more to your bottom line and legging in and out is definitely something you want to consider if you are working with those types of accounts. Obviously, that’s the type of account size we recommend and that’s one reason why we recommend it.
If you liked this lesson, if you’d like to learn more about some of the things we’ve talked about here, I do recommend our book, The Complete Guide to Option Selling: Third Edition. You can get the book at a discount directly from our website at www.OptionSellers.com/Book. They are fulfilled by Amazon so your privacy is guaranteed and all that good stuff. If you’d like to learn more about managed accounts with OptionSellers.com, you will want to get our Option Sellers Discovery Pack. This is an investor information pack, it tells you all about our accounts, how you qualify, everything you need to know about the accounts. You can request this on our website, it’s free… www.OptionSellers.com/Discovery . I hope you’ve enjoyed this lesson and we’ll be back in two weeks with another lesson. Thank you.