Surprising Key to Option Selling Returns – Managing Your Margin

Surprising Key to Option Selling Returns – Managing Your Margin
Sep

6

2018

Surprising Key to Option Selling Returns – Managing Your Margin

Working with Leverage is often a stumbling block for investors new to commodities options. Here is how to do it right.

If you’re a subscriber to our free book series on selling options , you’re familiar with the sports analogy of “defense wins championships.” Defense wins championships is a concept that translates directly to selling options. A core (if not THE Core) concept of option selling is this: It’s not what you take. It’s what you keep.

It is defense that will allow you to keep those championship premiums earned by your option writing offense. And in option selling, the backbone of your defense will be keeping an adequate cash reserve – or as we call it in the futures world – adequate margin.

The Fluid Nature of Margin Requirement

To sell a futures option, you as the investor, must put up a deposit in order to hold that option until you either buy it back or it expires. This deposit, in essence, is your investment in that option.

The margin requirement to hold your short option can change , depending on movements in the underlying market and the value of your option. For instance, if the market moves against your position and the value of your option increases, your margin requirement for that option can increase.

On the other hand, if the value of your option decays, your margin requirement can drop as well. While these margin changes are typically not substantial over the short term, they should still be kept in mind as you accumulate positions.

One of the reasons you sell deep out of the money options (ie: FUDOM method) is to give the market plenty of room to move without forcing you out of your position. Keeping a large cash cushion insures that you have plenty of excess cash to cover any short term margin increases in your positions – a “bend but don’t break” defense – if you will.

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How Large of a Cash Cushion Should you Keep?

In the portfolios that we manage, we typically recommend the following levels of cash reserves:

Conservative Portfolio – 50% Cash

Moderate Portfolio – 40% Cash

Aggressive Portfolio – 30% Cash

(A conservative option selling portfolio should keep about 50% of its value in cash)

The Many Advantages of Cash Reserves

Novice commodity investors will sometimes view this as equity which is not working for them. This is not true. Back up equity is playing a vital role in your overall portfolio.

Advantages to Holding Adequate Cash Reserves:


  • Ensures you do not Over-Position
  • Provides staying power to ride out short term adverse price moves (More winning trades)
  • Virtually eliminates margin call concerns
  • Smaller positions reduce impact of one bad trade on overall portfolio

A novice option seller mistake is to utilize 80-90 even 100% of the capital in their account to hold positions. This often results in being forced out of their positions on even the slightest hiccup in the market in order to account for small increases in margin requirements. It’s playing all offense, no defense.

The leverage available to you with futures options can be a wonderful gift but it can cut both ways. Novice investors tend to concentrate on potential profits and place less focus on protecting their downside. Experienced option sellers do the opposite. Holding adequate cash reserves is a big step in managing the gift of leverage responsibly.

With that done, you can better concentrate on scoring goals, runs or touchdowns in your portfolio. Because when it’s your net worth, your income, your retirement or a future for your kids and grandkids, you’re playing for a championship every year.


* Using margin and leverage to your advantage is a key concept of The Complete Guide to Option Selling 3rd Edition. To get your copy now, go to www.OptionSellers.com/book .

  1. Thank you Michael,
    Margin and anything to do with it has always been one of those areas I never could quite understand. This article nailed it for me! I can honestly say I now have a handle on what margin means. what a great feeling and wonderful break through!

    I so appreciate all the valuable information given by you and James. Can’t begin to express my utmost gratitude!
    Susan

  2. Thank you for the article!
    This is probably one of the most important concepts I’ve learned from your book. Now that I totally get it, it sounds so simple and straight forward, but before reading the book I would definitely have a problem with my money just sitting there not working for me. Now, I just cannot imagine myself doing it any other way.
    The high ROI of each option sale definitely helps, so even if 50% capital is set aside for cushion, I still find it very comfortable. Great article, as always!

  3. Richard Bobb Says:
    September 7, 2018 at 9:04 pm

    I just love the advice that your company constantly gives around keeping a significant cash buffer (around 50%) so as to not over-position. I also love the idea of selling deep out of the money options out to 12 months, or even more, to reduce the risk of assignment.

  4. Rich Martin Says:
    September 7, 2018 at 4:54 pm

    Hello, liked your story on position sizing for option sellers.

    Referring to your model/piechart showing 50% in cash, what do you mean by “size” of your investment (sector1+sector2 …etc in your model)? Is your “size” the premium you obtained by selling your futures option, is it the max risk of the option position or something else like the margin requirement? This is not clear to me.

    In my case, say I sell qty 50 60 point wide put spread contracts on S&P Futures for $0.70 each, yielding $1,750 premium which I get to keep mostly(0.70 X 50 X 50). But my max risk is $150,000 (60 X 50 X 50), so is my investment size this figure I presume? Thus my account should hold minimum $300,000 in cash to be conservative. If I held $200,000 cash only, my % investment would then be 75% & you would, by your model, consider me agressive, correct?

    • Michael Gross Says:
      September 11, 2018 at 7:47 am

      Rich,

      I would be careful using this model if you are trading only the S&P. This model is for trading a diversified, uncorrelated commodities options portfolio. I would NOT, under any circumstance, recommend putting 50% of your entire account into the S&P. There is nothing wrong with selling stock index options, if that is your thing. But trading ONLY the S&P is not a diversified approach and thus, one we consider extremely aggressive.

      Back you your question, we are basing the “position size” on the size of the margin requirement. Thus, if you collected $100,000 in option premium in a 500K account and the margin for those positions was $200,000, you would be what we call “40% margined.” If you sold more premium and your margin requirement was now $250,000, you would be at the 50% margin level.

      I hope that makes sense.

      Regards,
      Michael

  5. Klaus Geithner Says:
    September 7, 2018 at 3:21 pm

    I look at it to be my margin of safety (MOS).
    Thank you for handling my account responsibly and conservatively.

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