“Scaling” Your Short Option Positions
Better Capitalized Accounts Have Advantages in Option Selling. If You’re Not Using This One, You Should Be
As you know from the risk management chapter in The Complete Guide to Option Selling, the safest, most conservative method of limiting risk in option selling is by using the “200% rule.”
The 200% rule states that if you sell an option and it doubles in value, you exit . No questions asked.
The 200% rule works. It will keep you out of trouble. And for beginning option sellers, I strongly recommend it.
(scaling)… makes your average entry price higher and thus, your breakeven level lower.
However, for the more advanced option seller working with larger amounts of capital, the 200% rule is more like an intro to risk management. The advanced option seller learns the basics, and then learns to build on them to make his portfolio more efficient and higher yielding.
Today, you’ll discover just such an advanced technique. It’s the professional technique of scaling your short option positions.
Higher Capital – Using Your Advantages
Investors who “dabble” with options typically don’t use scaling. Selling 1, 2 or 3 options at a time usually means setting a stop (internal or external) and exiting when it is hit.
But if you’re selling options as a core income or growth strategy, working with a $1 -$5 million+ portfolio, you have some advantages.
One of those is the strategy of “scaling.” Scaling is the process of gradually entering or “building” a position. Using this kind of approach provides a wealth of benefits. Most notably is that if you are selling calls into a rising market (or puts into a falling one), scaling allows you to “average in” to your premium. Thus, if you got $700 for your option today, you might get $725 tomorrow or $750 next week. Few of us can pick the exact top in the market. Scaling in to a position allows you to begin entering a fundamentally favorable position and still take advantage if your timing is not perfect (it rarely will be.)
If you’re not yet scaling in and out positions, you should be.
EXAMPLE: Scaling In to a Position
Suppose you have identified a favorable option to sell. For this example, we will assume you are selling calls. To be proportional to your other positions (as per the submarine portfolio model for option selling) you decide target is to collect $80,000 in premium from this trade.
As each option is currently selling for $750, you enter orders to sell 25 of the options today. Tomorrow, the market rises slightly. Now the option is worth $800. You sell 25 more. Next week, the market keeps rising. It has now hit a value of $850. You sell 25 more at this higher premium. 3 days later, the market is still rising. You sell 25 more at a $900 premium.
Scaling into a position. Same strike, different premiums.
Your total premium collected is now $82,500. Had you sold your entire position on day 1 at $750, you’d be holding a group of options that are all $150 against you. As it stands, only about ¼ of your position is that far against you. The rest are less so. A slight pullback in the market means the latter group of options sold will already be profitable.
It also makes your average entry price higher and thus, your breakeven level lower.
Scaling into a position is a professional grade strategy suitable (and recommended) for larger accounts.
The bigger benefit, however, may come from scaling out of a position.
Scaling Out – Big League Risk Management
Scaling out of a position may be even more valuable to you than scaling in. The 200% rule is a powerful risk management tool. But it is most often the case that the options you exit at the 200% rule will ultimately expire worthless.
Using the above approach to “scale out” of your option position can be a powerful way to keep a lid on losses while still preserving a portion of your position that may ultimately prove profitable.
Example: Scaling Out of a Position
For instance, suppose you sold 100 Natural Gas call options for $800 each (you didn’t scale in – shame on you.) You’ve collected $80,000 in premium. The option premium doubles. Instead of simply blowing out of your entire position, you may simply scale it back, buying back ¼, 1/3, or ½ of your position. You scale it back to where it is once again proportional to your other positions and overall portfolio.
Thus, if you are following the submarine portfolio model, your portfolio may look like this right before you begin exiting.
Your Natural Gas Position has increased in value. It is taking up a disproportional amount of value (and likely margin) in your account.
With the value of your wheat position doubled. But you still believe in the trade. As the option is still well out of the money, you decide that rather than blowing out of your entire 100 positions, you will close out only 50 of them, taking a loss on them. This brings the wheat position size back in proportion to your overall portfolio.
With Half of the Natural Gas Position Closed Out, your position is now back in proportion to the rest of the portfolio
The Cash Benefit of Scaling Out
Taking a loss on half of your position may sting initially. But in a proper scale out, it may only be a temporary condition.
For instance, let’s suppose that after you close out half of your natural gas positions, the natural gas market stops rising, then begins a slow but steady decline. 5 months later, your remaining call positions expire worthless. Your natural gas position you initially established has broken even!
You gave up $40,000 on the ½ close out but made it back on the options that expired.
This may not feel like a win to you, but it is. Why? Because only a small percentage of your option sales will be losers. Thus, if you can turn some of those losers into break even trades, it’s going to pay big dividends over the course of a year. A loss prevented can be as big a win as a successful trade .
Your Take Away
You’ll see it over and over again in our materials and videos that, as an option seller, the way you structure your portfolio is MORE IMPORTANT that selecting individual positions.
If you’ve moved beyond the “dabbling” stage and have made option selling a core component of your overall producing assets, a properly structured portfolio is MUST.
However, working with higher capital levels also provides you some acute advantages . One of those is the strategy of scaling.
The examples above are simplified for demonstration purposes. Scaling can (and should) be done in small intervals for even more efficiency.
Scaling can also be done across different strike prices, further spreading risk and improving the durability of the position.
Scaling is such an important concept for larger accounts that you will be finding more references to, and lessons about, in our video and materials in 2019.
In the meantime, today’s take away is thatscaling in and out positions is a means of spreading risk,avoiding loss and at the end of the day, putting more money in your pocket by year’s end.