How Do you Manage Option Selling Risk? (Crucial First Step)
The Margin CushionHow To Protect Money In Option Selling
Hi this is Michael Gross, Co-author of McGraw Hills “The Complete Guide to Option Selling” and Director of research here at optionsellers.com. I’m here with your bi-monthly option seller video lesson. The topic of this week’s lesson is The Margin Cushion. You know I talked to a lot of prospective investors here at our firm and one of the top questions I get is:
- 1. How are you going to protect my money?
- 2. How are you going to protect me from downside risk? There is a lot of risk in option selling
- 3. How do I avoid that?
- 4. How do I stay away from losing money?
And there’s a couple answers to that question but one of the primary answers is option selling is no different than any other investment, in that you can lose money in it; look we’re all adults here you’re going to have losing traits. Option Selling is not perfect; we think it’s a superior strategy but it’s not perfect and if you’re going to be an option seller you’re going to have to accept the fact that sometimes trades are going to lose money, sometimes your account’s going to lose money. The key is when you do lose money you lose it the right way, you lose it in a limited way, you lose it in a controlled way that enables you or puts you in a position to be able to bounce back next week, recoup the losses next month or even in some cases next year, but you want to keep that in a controlled capacity, keep you in the game and puts you in a position to make the money back in the future time and how we do that is with systems.
Risk management systems all the way along, that’s what separates an amateur from a professional or sophisticated investor is those systems. One of the systems we’re going to talk about today is the margin cushion and this is a very crucial risk management system; if you want to be a successful option seller you need to understand the concept, that’s why we’re going to talk about it today. Before I go any further, if you’d like to learn more about concepts like this, about risk management systems or option selling in general – how to be successful, you’ll learn a whole plan for how to be a successful option seller in the complete guide to option selling. It is on sale now at our website www.optionsellers.com/book you could get it…if you buy it through our website you get a 40% discount off the cover price where you get it at Amazon or anywhere else. So what is the margin cushion? Well before we talk about what a margin cushion we’re going to talk about why you need it.
As an option seller you have two types of risk; there are two types of primary risk that you’re going to have to deal with in the market:
The first one is that your option goes in the money.
Now this is something that Stock Option sellers deal with a lot and in some cases it’s what they want, if they sell or put underneath the market and price of the stock goes down and they get that stock put to them sometimes that’s what they want because of trying to buy the stock at a cheaper level. Same thing if we are selling a call above the market, the market goes up, it takes them out of the profit so that it’s not all bad thing if you’re a stock option seller. For commodity option seller who are just selling for premium, you don’t want the option going in the money because when an option goes in the money it’s value starts increasing rapidly, we want to avoid that, fortunately if you’re using the method we subscribe to and we prescribed in our book and our other materials, the FUDOM method that’s not a concern. Why because your selling option so far out of the money that… the chances of them going in the money are remote at best, not only that but you can see them approaching that strike place so there’s plenty of time to get out of the option in almost every case, long before it ever goes in the money.
So that’s not a big concern if you’re selling commodity options using the FUDOM method. Your primary concern is the second form of risk we are going to talk about today.
The second form of risk is that the market makes an adverse move against your position and your option value increases. What does that mean? Well one it means your option value increases so it’s using a little more of your capital but can also mean your margin requirement increases; doesn’t always mean that but it can, so what that means is that it puts you in a position where that positions pulling more cash and you want to be able to provide that cash to it if it’s still a good position. That’s what we are going to talk about today.
So what is a Margin Cushion? Well a lot of stock investors or traders that aren’t used to commodities aren’t used to selling options they don’t know about leverage, for instance stock investors often think well I need to have a 100% of my account working in the market otherwise it’s not working for me but when you’re dealing with option selling or with commodities that’s not the case because as we just talked about your margin requirements can fluctuate so you need to have a backup reserve of cash in your portfolio to account for that; that backup reserve is what we call the margin cushion. Let me do an example, okay so let’s suppose you’re working commodity option selling portfolio you have a million dollar account and you take that money and you eventually get it invested; you get it at all invested all 1 million is working in the market and fully positioned. Right?
So where you want to be you are using all your money you will if you’re trading stocks or whatever because you want the money working for you. Now you have 100% of that cash in positions; if any one of those positions, any one of them makes a big move up or a big move down against your position what’s going to happen? The value of the option is going to go up, your margin requirements likely going to go up. What does that mean? It means you’re out of money, it means you need to come up with some more money or you can’t hold all your positions, so you’re either going to be forced out of a position that you may not want to get out of or you’re going to have to put more money in your account. Well nobody wants that.
So what’s a counter measure of that? How do we prevent that?
Let’s take the same million-dollar account. What we’re saying is you don’t put 100% of your account in positions, you take 60% of your account; you put that in positions; 40% stays in cash that’s your margin cushion. That is a crucial aspect of any commodities option selling portfolio.
Now is 40% a set in stone figure? No, that is something I use for this example. In fact, for beginning investors new to option selling, I know most people watching this are not beginning investors but for option sellers that are just starting out in commodities, you don’t have any experience with commodities this is your first allocation to this asset class; we recommend keeping 50% of your equity as a margin cushion, as backup cash that accomplishes a number of different things. First and foremost it gives you plenty of capital to write out any adverse moves in your positions that you don’t want to get out of because this is the key. If you sell an option the only time you want to get out of that option is:
1. If it’s decayed enough or if you want to take profits on it or
2. It hits your risk parameter
You don’t want to be forced out of that option simply because you don’t have enough margin, so this allows you to do that, it allows you to stick to your system, it allows you to stick to your risk parameters and each individual position and trade in that a controlled manner rather than having the market force you out of a position. You want to be getting out of positions on your own terms and that’s one of those positions triggers a risk parameter, hits your stop what have you. This allows you to do that.
Now a lot of…. I don’t get a lot of pushback on that but some people when they first start out they say well yeah that’s great but that capital is just sitting there it’s not working for me, it’s dormant and that’s not the case, that’s not the way to think about this and the way I advise thinking about it is this. You think about our army – our great men and women serving in the Armed Forces right now. You have an active duty military and it consists of so many soldiers, support personnel and what have you, so you have your active duty Army over here, but over here you have your reserves; so if a national crisis comes and all these active duty personnel were called on here but over here you have your reserves so a national crisis comes and all these active duty personnel were deployed who do you call on?
You turn to your reserves because you need them; you need them there to back up. Are these wasting assets? Are these people not being used? No, they are a crucial part of this, a crucial part of this effort, a crucial part of the whole organization; that’s the same way you should think of your backup margin equity. So your backup margin in your account is working capital, it is serving you in a very valuable way it should not be thought of as just excess cash sitting there not doing anything for you, serving a very valuable function.
Now the last point I want to make here is keeping a cash cushion is only one part of overall risk management in an option selling portfolio. Obviously there’s diversification, there is individual risk management on positions etc. etc. and of course those are all discussed in our book and our website; however the margin cushion is probably the foundation, it’s the first concept to internalize when you’re talking about a responsibly managed option selling portfolio. It’s what I’d recommend to you.
I hope you gain something from this video we’ll see you in two weeks. Thanks for coming I also wanted to mention for those of you that are interested in potentially working directly with us in a managed option selling portfolio, I do recommend getting our investor discovery kit. Tell you all about our accounts, our portfolio, how you get started, etc.
You can request that our website at www.optionsellers.com/discovery.
Thanks for coming – we’ll see you in two weeks.