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.
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 .