How to Avoid the 3 Biggest Mistakes in Option Selling
Michael Gross, co-author of McGraw-Hill’s The Complete Guide to Option Selling, explains how to target larger, more consistent yields by avoiding these 3 common mistakes made by new option writers.
Read more insights here How to Avoid The 3 Biggest Mistakes New Option Sellers Make
Hi, I’m Michael Gross of OptionSellers.com. Welcome to this edition of The OptionSeller Email Seminar. The subject of this new email seminar is The 3 Biggest Mistakes New Option Sellers Make. This is an important seminar, especially if you’ve either never sold options or you’ve only ever sold stock options, because what we’ve found is avoiding the wrong things to do is just as important as making sure you do the right things in option selling. What we’ve identified, and this comes from not only James’ experience who has been working with traders since 1984, I myself have been working with option traders and high-net-worth investors since 1996, so I’ve had about 18 years of experience now, I’ve talked and worked with literally hundreds of option traders. We distilled the type of mistakes they make down to the top 3 that we felt when it comes to commodities trading. The reason for this, we’ll tell them to you now and you can avoid them in your trading and hopefully make more money trading options.
Let’s just jump right in here. The first mistake new option traders make is over-positioning in the market, without a doubt. I’ve seen this happen over and over again. A new option seller comes into the market, “I want to sell my first commodity option.” So, let’s say he wants to trade crude oil. Crude oil is trending up. “I’m going to sell a put option.” So, he sells a put option below the market and, let’s say, he collects $600 and he sells 10 of them. He sells 10 options, he makes $6,000, and he takes that into his account. What happens? He’s right, and guess what happens? Crude oil messing around and it keeps going up. 90 days later, his options expire and he made $6,000. “Wow! Option Selling is the greatest thing since sliced bread! You know what I’m going to do next time? I’m going to do that same trade, only I’m going to sell 30 options.” He sells 30 options. Now he takes in $18,000. First time it worked, that one should work too, right? Well, what happens when he triples down on his money? That’s almost guaranteed to be the time the market reverses and goes down through a strike, he has to liquidate and take a loss.
When you’re selling commodity options, you’ve got a basket of undiversified assets you can sell options in. You don’t have to put all your eggs in one basket, you certainly don’t have to do this, and you certainly don’t have to get ahead of yourself in using up your margin and over-positioning. I’m going to draw you a little pie chart here and it’s something I would internalize as a trader, to always remember, especially as you’re selling commodity options. You’ll see this chart on a lot of our material. You’ll also see it in The Complete Guide to Option Selling. This circle is the money in your account. So, let’s say you have $500,000 in your account, your option selling account. Your target as a semi-conservative option seller is to keep 50% of that money in cash. Commodity options have margin requirements. If the position is moving against you, your margin requirements can change. You want to have an excess cash cushion if those margin requirements are going up. You want to have the cash to be able to absorb that. You don’t want to be forced out of your positions. You want to be getting out of your positions when they hit your risk parameter, not because you can’t afford them, okay?
Of the rest of your money, you want to have it diversified over at least 5 or 6 different commodities. You don’t put all your eggs in one basket. That’s basic investment 101. The same holds true in option selling in the commodities markets. So, instead of betting the farm on those crude oil puts that can’t miss, you want to diversify over several different un-correlated sectors. Maybe some money in soybeans, maybe some money in gold, maybe you sell some put or call premium in cattle… whatever you’re trading, you want to stay diversified. #1 mistake new option sellers make is they over-position, they sell too many options, and all the sudden they don’t have a cash cushion at all and they are entirely all over the map loaded-up and one little move and they’re out of margin. That’s why people get so afraid of margin calls in commodities, but they’re easily avoided by just following some simple rules. So, that’s the #1 mistake you want to avoid.
I spent a lot of time on that one, but we do want to touch on two other things here you do want to avoid. The first one is not having an exit plan. If you’re an experienced investor you probably know the importance of having an exit plan before you go into the market. If you just enter a position and you don’t decide at the time you enter that position where you’re going to get out, what happens? You begin trading on emotion. That’s the death nail of your portfolio when you start trading on emotion. I moved to Florida 20 years ago because I liked scuba diving and I wanted to be a scuba diver. One of the first things I learned in scuba diving is “you plan the dive, you dive the plan”. The exact same thing holds true in trading. You plan the trade, you trade the plan, that way once you’re in to trade, you’re not deciding where you’re getting out, you already know where you’re going to get out. That’s a big mistake new option sellers make. They’re gung-ho, they want to sell the premium, get the premium into their account, and they don’t stop to think where they’re going to get out. If the thing doesn’t go my way, where am I going to get out? Is it when the premium doubles, is it when the premium triples, is it when the market moves to a certain point? There’s a number of different ways you can do it. We talk about it in The Complete Guide to Option Selling. The important thing is you want to know which one of those you’re using. You want to know what the plan is before you’re in the trade.
Third mistake, and I want to check my notes here to make sure I communicate it to you correctly. We’ve talked about this in past seminars… it’s Selling Options Too Close to the Money. Again, we’ve covered this in various materials. It’s one of the first things you have to learn, especially in commodities, is that you don’t sell options 30 days out that are at the money. You trade time for distance. You sell options deep out-of-the-money. So, one of the biggest mistakes, especially stock options traders, they’ll try and sell these 30 day options and to get any premium at all they have to sell them right where the market is trading or slightly out-of-the-money. One little hiccup puts them in the money and then you’re dealing with all these risk issues and where to get out and should I exercise it? We don’t want to deal with that. This is premium collection here. Stay deep out-of-the-money. Don’t worry about little market hiccups. You want to focus on the fundamentals.
I hope you found this helpful. These are just some general guidelines you can use. Hopefully it will make you more profitable as an option seller. If you want to get some more information, obviously our report on our website is something I always recommend to investors. Our book is out there in a new third edition… The Complete Guide to Option Selling. I always recommend that if you’re interested in a subject. Of course, if you want to learn how to work with us directly, you can request our investor Discovery Kit, it’s free on our website, or call us to schedule a consultation… whatever you’d like to do. Thank you and good luck trading.