Sleep at Night Risk Management for Option Sellers

Sleep at Night Risk Management for Option Sellers
Jun

8

2018

Sleep at Night Risk Management for Option Sellers

Despite the naysayer’s crows of “unlimited risk”, there are several reliable ways of managing your risk in option selling. Here are 3 Top Methods for “keeping the wolves away.”

You’ve tracked this option for days through the market prairie. You’ve studied its underlying fundamentals. You’ve carefully selected your strike and stalked it until it hit your target premium. Finally, you’ve pulled the trigger. You downed it. The premium is in your bag. You’ve landed your Buffalo.

Most of the time, you carve up your meat, take your hide and go home.

But every once in awhile, there are challenges. The market wolves come around. They want your Buffalo. And while they’re at it, they’ll take a bite out of you too, if you let them.

Such is the game in Option Selling. Select agreeable markets and sell your options right and most of the time, you get worthless expiration – and hopefully, get it quietly. But what happens when it doesn’t quite go as planned? What happens when the wolves come howling?

Managing risk in option selling has been made out to be a complex subject by other authors that have attempted to tackle the subject. But it doesn’t have to be. I’ve read several “experts” who advise strategies of “adjusting” and “re-balancing” of positions that don’t go right. But that is going to battle with the wolves.

Option selling, done right, should be a strategy that allows you to sleep well at night. That means no battling wolves, or anything else.

Don’t Battle the Wolves

Experience has taught me that battling wolves for the most part, doesn’t pay. It taxes your energy. You can get wounded. And much of the time, it’s a losing fight.

Even more importantly, the time and energy you spend battling the wolves could be much better spent taking other buffalo.

In other words, you shouldn’t, nor do you have to, be a hero in option selling. You’re not defending your homestead here. It’s an option premium. There are plenty out there. In my experience, the smart cut and run.

In over three decades of trading, I’ve fought my share of wolves. And I’m here to tell you, when it comes to selling options, cowards have bigger bank accounts.

The Three Methods of Managing Option Selling Risk

There are two types of risk management in a short option portfolio. There is individual position risk and there is overall portfolio risk. Today’s lesson will focus on individual position risk.

In managing risk on individual trades, if the market moves against you, our premise is the best course of action is to simply exit the trade at a predetermined exit point. Don’t try to fight the wolves. Exit first. Then reassess.

The question then becomes where to exit? That is the subject of today’s lesson. Below are the three methods of managing risk on your short option. The more precise statement is the three methods of determining where to exit your short option position.

The 3 Methods


  1. Method #1 – Exit if your Position Goes in the Money.

    Your option can only hold value at expiration if it expires in the money. Therefore, it only goes to reason that you should hold it until it goes in the money, right? But it’s not always that easy. Option values can increase prior to expiration, at times substantially, even if the option is out of the money. This can mean paper losses and increased margins prior to expiration. For that reason, you probably don’t want to use this method unless your option is very close to expiration and you’re willing to watch it pretty closely through expiration. I have used it successfully in that situation. Otherwise, this is the most aggressive form of risk management. I recommend it only to the most aggressive, risk tolerant option sellers.

  2. Method #2 – Exit based on a Predetermined Price Point on the Chart.

    Fundamentally based entry combined with technically based risk management can be a successful formula for those willing to take on a bit more risk. Method 2 dictates that you hold your option position unless a predetermined technical price level is violated. Thus you could sell a call and resolve to hold it until a key resistance point or trendline is broken. This method can work well in volatile markets where option premiums can have a bit more play in the short term. I’ve used this method effectively in these kinds of markets. Option values, however, can see short term swings in volatile markets. To employ this approach, you must be willing to ride out those swings. Method two is a medium level of risk management, suitable for semi-aggressive option sellers who want to use a chart based trigger for exit.

  3. Method #3 – Exit based on the Premium Value of your Option.

    This is the simplest and most conservative form of risk management. It is also the one we use most often in our managed portfolios. You sell an option for a premium. If the market moves against you, depending on how fast and how much time is left on the option, that premium value can increase. Method #3 dictates that if your option reaches a predetermined premium value, you simply buy it back at that level and take the loss. I often suggest this level be double or triple your original premium. Thus, if you sell a coffee put option for $600 and you set your risk point at “double premium”, you would exit if that premium ever rises to $1200. Risking to double premium is a rule I recommend to new option sellers. We call this the 200% rule and while it will take you out of some trades that will ultimately expire worthless, it will tend to keep you out of trouble. Do I always use it in my managed portfolios? Not always. But I do most often use premium based risk management, and I recommend it to you in most instances.


In The Complete Guide to Option Selling , we discuss credit spreads and “rolling” options as methods of risk management. But these are strategies to use before or after entering or exiting your trade. Methods 1-3 above are your strategies for exiting a current losing position.

Memorize them and learn how to use them. For in a portfolio where most of your positions will indeed expire worthless, the whole ball game becomes handling the few trades that move against you.

Managing these correctly goes a long way towards preserving your hard won premiums and keeping your portfolio on a consistent path of growth.

In other words, it will keep the wolves away.

For more information on managed option selling accounts with OptionSellers.com, visit www.OptionSellers.com/Discovery for a Free investor information kit.

  1. rick marshall Says:
    June 11, 2018 at 5:38 am

    Regarding the 200% rule. What if the option that is going against you never reaches 200% but remains in the money. How close to expiration do you go until you buy the option back?

    • Michael Gross Says:
      June 11, 2018 at 3:13 pm

      Rick,

      You should be selling options so far out of the money that you will never be trading anything in the money. If you are selling deep out, the 200% rule will have you out of the option long before it ever goes in the money. If your option does go in the money, I would recommend closing it immediately. And reconsider your trading strategy.

      Regards,
      Michael

  2. First: I love your book and I also love your blog and especially your videos. They help me very much to get a feeling for some particular markets. So thank you very much for sharing this valuable information with us!

    What exactly do you mean with fighting the wolves? I sometimes give in to the temptation to sell another bunch of options of the same type and strike which is moving against me. Although I know I should not do that. Are there any other examples you thought of while writing about the wolves?

    Many greetings from Germany!

    • Michael Gross Says:
      June 11, 2018 at 4:05 pm

      Paddis,

      Just a figure of speech. We were using “wolves” as a metaphor for market losses. 🙂

      Thanks,
      Michael

  3. sabahnuha98@yahoo.com Says:
    June 9, 2018 at 6:06 pm

    Can you address what to do when brokers raise their margin on option sellers. Tradestations doubled their margins above SPAN. They driving option sellers out of business.

    • Michael Gross Says:
      June 11, 2018 at 4:04 pm

      Sir,

      Individidual Brokerages can raise margins in response to volatility or other external factors. If you feel them too high, you can always shop around for other brokerage houses more friendly to selling options.

      Regards,
      Michael

  4. Dear Michael: Always great info, but sometimes can be unwieldly. Take Wheat. I have a March 19 Strangle – Naked Put at $480 and Naked Call at $710 which is a pretty good $230 range. When I entered the Contract, the contract values for both were $571.50. The value now is $580.50. Not the greatest contract value movement. Normally you would think I would be up in dollars a bit on the Put and maybe down a bit in the Call. However, Wheat has always been a bit peculiar. Right now, I am down on both (if you can believe) for appx aggregate total of – $1,275. And to add insult to injury, the Put is OOM appx 17.3% and the Call is OOM apx 22.3%. The fundamentals are for higher wheat prices due to drought and lower ending inventories.
    I have a lot of room to hold on to this Strangle. Any feelings on this? It is peculiar but Wheat has never reacted to normal fundamentals for me. Thank you. Alan

    • Michael Gross Says:
      June 11, 2018 at 3:38 pm

      Alan,

      Wheat got a jolt of volatility over the past 30 days which has helped hold up both put and call values. Your strangle seems solid for now. I cannot give you trade advice. However, as a general rule, you put the trade on and hold until a risk parameter is violated. If you’ve set the right risk parameters, there should be no questioning what to do.

      Hope that helps.

      Regards,
      Michael

  5. Randy Chambers Says:
    June 8, 2018 at 9:00 pm

    Hello, Michael
    These methods don’t apply to strangles. Or did I miss something?
    To facilitate peace-of-mind if I’m unable to frequently monitor my trades, in thinkorswim I would use an OCD bracket for each leg (but especially for /CL). Conversely, however, if I am able to frequently monitor, I just roll my trades to maintain a relatively equal delta for each leg. Indeed, the trading fees for rolling cost substantially less than a credit-spread strategy.

    • Michael Gross Says:
      June 11, 2018 at 3:34 pm

      Randy,

      These strategies can apply to strangles. James addressed this in last months podcast. They apply to strangles but we give strangles a little more leeway (ie: risk one side to triple rather than double.)

      These can be used in conjunction with rolls. The strategy you now employ is valid.

      Regards,
      Michael

  6. Chris A. Says:
    June 8, 2018 at 8:13 pm

    Michael,

    For option 2, you state,”This method can work well in volatile markets where option premiums can have a bit more play in the short term. I’ve used this method effectively in these kinds of markets.”

    Can you tell me how you define what a “volatile market” is and/or tell me which markets you have found that this method works well for.

    Thank you,

    Chris

    • Michael Gross Says:
      June 11, 2018 at 3:30 pm

      Chris,

      Volatile is a relative term but typically refers to volatility levels rising substantially over historical norms. Any market can become volatile – which can be an opportunity. For a better discussion on volatility, I refer you to chapter 17 of The Complete Guide to Option Selling, 3rd Edition.

      Thanks and hope that helps.

      Regards,
      Michael

  7. AS PERFECT AS EVER!
    JOHN

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