Managing Option Selling Margin for More Consistent Results
Michael Gross, co-author of McGraw-Hill’s The Complete Guide to Option Selling, explains How to Maximize the performance of your option selling account by keeping the right amount of back up cash.
Hi, this is Michael Gross of OptionSellers.com here with your bi-monthly Option Seller Video Lesson. The subject of this week’s lesson is Managing Your Option Selling Margin, and we have a good one here for you today. Before we get into the subject, I do want to mention that if you do want to learn more about topics like managing your margin, you’ll want to pick up a copy of The Complete Guide to Option Selling: Third Edition. It’s available on the website now at a 40% discount. For those of you that don’t have it yet, you might want to check that out. In addition, for those of you that do have the book or even if you don’t and you’re interested in possibly working directly with us, you’re a high net-worth investor who wants to sell options on a managed level, we do have The Option Seller Discovery Kit that I do recommend to you. It comes with a 30 minute DVD of James Cordier’s seminar to high net-worth investors. It also comes with a full pack that tells you how you can get started working with us, what type of programs we have available, etc. If you’re interested, you can request that at our website, as well… www.OptionSellers.com/Discovery .
So, let’s talk about managing your margin in an option selling account. If you read this month’s newsletter, we did write an article about this in which I used an old sports axiom; it’s called defense wins championships. Actually, the full saying goes, “Offense sells tickets. Defense wins championships.” I researched this a little bit and can’t really put my finger on who said it first, there’s a lot of coaches that it has been attributed to, but you’ll find that it kind of rings true in just about every major sport out there, from football, baseball, basketball, to ice hockey. A team that wins a championship, they might have a good offense but almost all of them have a good defense. A defense not only protects your downside, protects from an opponent scoring against you, but it makes your offense better. Your offense can play more relaxed, it can play more confidently, and the same will hold true in your trading, no matter what kind of trading you’re doing but, in particular, to selling options. That’s the value of knowing how to protect that downside. We’ve been talking a lot about it recently in our newsletter and our articles. You may have seen our article on Managing Individual Position Risk, Managing Overall Portfolio Risk, and the third part of that is Managing Your Margin. A lot of people, especially starting out with commodities options, they aren’t real familiar with what that means. It’s such a major part; we want to talk about it today.
In commodities, the system that determines the margin requirement for your option is called span. If you sell an option, for example, for $600 you’ll have a margin requirement that is determined by span. Now, that margin requirement might be $1,000, it might be $1,200, or it might be $1,800, it all depends on your market that you’re trading. One thing for sure, it’s going to be a lot less than stock option margin, but what most people don’t realize is, depending on the movement of the market, your margin requirement can go up or it can go down while you’re in that position. One of the big roadblocks new option sellers face when they come into commodities is they can’t deal with this. Now, granted, most of the time those fluctuations are going to be minimal, but you have to be able to account for that, nonetheless. What do I mean by that? Well, let me demonstrate by chart. If you’re in a position and you’re using a lot of the systems we’ve recommended for selling options, such as the FUDOM method, fundamental deep out of money options, you want to be getting out of those positions only if they hit your risk parameter. You do not want to be getting out of them because the margin increased slightly and now you’re over balanced in one position, okay? You don’t want to be trading because you’re afraid of margin calls. That’s a common fear I get from investors that have never invested in commodities before is, “Aww, I’m going to get a margin call.” Well, there’s ways to avoid margin calls and one of them is you keep a big cash cushion in your account. We have covered this before in other lessons, but we’re going to go into it a little bit more deeply today.
The biggest part of margin management in your account is keeping the cash cushion in the account, and why do we do this? Well, we do this because of that… the shifting margin requirements on your position. So, you have all your positions over here and one of them is moving against you, the margin requirements are increasing. You don’t want to say, “Oh, the margin’s too high. I’ve got to get out.” That’s not why you want to be getting out of a position. You want to have plenty of cash here that if it starts pulling more margin it draws from this, it draws from your cash bank. That’s why it’s there. I know, especially from talking to investors, I got a question the other day, “Well, that cash is just sitting there. It’s not doing anything for me.” It’s a difficult concept to get your hands around because I had to explain that, actually, it’s doing a lot. It’s very active working capital there, it’s serving a purpose, it’s not doing nothing. It’s your defense. It’s covering potential margin increases in these positions you have over here. It serves a very vital function and it’s something you should always do if you’re selling options, especially futures options.
How much of this cash should you keep as a backup? Well, let’s talk about that, too. In the portfolios that we manage for high net-worth investors, a conservative portfolio would keep somewhere around 50% of his equity in cash. Want to be a little bit more moderate, a little more aggressive, targeting slightly higher returns? He’s going to be positioning more of his funds in the market and keeping a little less in cash, so he might keep 40% of his equity in cash. Now, if you’re an aggressive investor and you want to target the higher returns, that means putting more of your money in the market, so it means keeping a little bit less in cash. An aggressive investor might only keep 30% of his equity in cash. We’ve tested these over the years and, if you’re trading this at home, this will serve you well deciding on which approach you want to take to selling options in your portfolio. If you’re just starting out, I would recommend starting on this end until you get a little bit more comfortable. Keeping a big cash cushion, you really can’t go wrong with. It’s something that gives you a lot of leeway and flexibility in your positioning.
So, let’s review the four big advantages you get from keeping a cash cushion in your option selling account. First big one, your fear of margin calls is diminished. Keeping a 50% cash cushion in your account virtually eliminates, I don’t want to say 100% but just about, ensures you’re not going to get a margin call. Anything is possible, nothing is guaranteed, but if you’re keeping that big of a cash cushion in your account it’s very unlikely you’ll ever see a margin call. That’s one of the reasons we do it and dealing with margin calls shouldn’t be a concern you have when you’re selling options. This is meant to be a program where you’re gradually collecting premiums each month. We’ll leave that to the run and gun futures traders. Second big advantage, and we’ve talked about this in a prior lesson, it keeps you from over positioning. If you have half your portfolio in cash, you don’t have to worry about taking on too big of positions. If you’re sticking to our prior guidelines of keeping small positions spread across a variety of markets, that big cash cushion there will keep you from over positioning, getting too many positions in your account for the size of account that you have.
Three, it gives you staying power. You’ll be able to stay in your trades longer, like we talked about earlier, you’re not going to be forced out of them because your margin fluctuates a little bit. You want to stay in those positions because, at the end of the day, odds favor them expiring worthless, so keeping a big cash cushion allows you to stay in your positions longer until they hit your risk parameters… you’re not getting out because of the margin. The last but not least, by not over positioning, you are keeping manageable positions. That reduces the impact of a bad trade, so when you do have a losing trade it’s not having an outsized impact on your overall portfolio. Four big advantages of keeping a cash cushion in your account. It is an integral part of your option selling defense. It completes your defense and if you want to be a great option seller and you want to be taking consistent premiums each month, remember: defense wins championships. It’s a great place to put your focus if you want to be an option seller.
If you’d like more information about an account, you can always feel free to give us a call. As I mentioned earlier, we also have the Discovery Kit available if you’d like to learn more first. Thank you for watching this week and we’ll talk to you in two weeks.