Sleep at Night Risk Management for Option Sellers
Three Top Methods from the Option Selling Pros
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.
NEW VIDEO LESSON: Watch OptionSellers.com’s Michael Gross explain Managing Your Option Selling Risk.
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.
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.
Our experience has been that this is not the case.
In other words, you can try to be a hero – try to “fix” a losing position and fight off the wolves. Or you can be smart. 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. The smart live to fight another day.
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. (The “Lesson of the Month” in the upcoming April Option Seller Newsletter will address managing your overall portfolio risk for maximum results.)
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
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.
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.
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 I recommend to most new option sellers. 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.
James Cordier is the founder of OptionSellers.com, an investment firm specializing in writing commodities options for high net-worth investors seeking outsized returns. James’ market comments are published by several international financial publications and news services including The Wall Street Journal, Reuters World News, Forbes, Bloomberg Television News and CNBC. Michael Gross is an analyst with OptionSellers.com. Mr. Cordier’s and Mr. Gross’ book, The Complete Guide to Option Selling 3rd Edition (McGraw-Hill 2014) is available at bookstores and online retailers now. For more information on managed option selling accounts visit www.OptionSellers.com/Accounts ($250,000 minimum investment)