Surprising Key to Option Selling Returns – Managing Your Margin
Lesson of the MonthA large cash cushion is your defense against volatility and can help make you a big winner at year’s end. Just ask the 91’ Pittsburgh Penguins.
It’s May in North America, the month when the top teams in the National Hockey League battle it out to see who plays for the Stanley Cup. Even if you’re not a hockey fan, you’ll probably agree that many lessons from sports can be transferred directly to investing. I learned one of these lessons a long time ago –one that I now help apply directly to option selling portfolios today. If you want your option selling portfolio to be a consistent cash producing asset, the lesson I learned from the NHL so many years ago (below) will help you make it so.
“Defense Wins Championships”
I grew up in a small town outside of Pittsburgh, Pennsylvania. As such, I was brought up a sports fan. And in March of 1991, the city had gone absolutely hockey crazy over the once pathetic Pittsburgh Penguins. For in March of 1991, Pittsburgh had one of the most prolific offenses the NHL had ever seen featuring names like Mario Lemieux, Paul Coffee and a young Jarimir Jagr. Pittsburgh was a finesse team that relied on scoring a lot of goals to win – as their opponents scored a lot of goals against them.
1991 was a time when, as the song says, I wore a younger man’s cloths. I had also become somewhat of a hockey fan. During this time, ( I had just begun studying commodities and was not yet employed in the field) I worked for a computer wholesaling company located right in the heart of the city. As it happened, a few months earlier, the firm had inked a deal with the brother of Penguins forward John Cullen. To my delight, I had been assigned (with others) to work him. By pure coincidence, John happened to be there one day when I came for a meeting – and I had the pleasure of meeting him. Cullen was a goal scorer on a team of goal scorers. (He also turned out to be a really nice guy.)
On March 4, 1991 I awoke in the morning to hear some startling news. John Cullen had been traded to the Hartford Whalers in a multi-player deal that brought to Pittsburgh 3 large, brutish defensive players. I was devastated. How could this be? Why trade one of your star goal producers (and my personal connection to the team) right before the playoffs? What were they thinking?
I found out that night when a local sports radio personality explained the logic by repeating an oft used phrase I never forgot. “Offense sells tickets. Defense wins championships.”
Just like in 91’, the team that wins this year’s Stanley Cup will likely have a strong defense. If you want your portfolio to give you a trophy at years end, you’ll want to build a strong defense for it now.
The Pittsburgh Penguins went on to win the Stanley Cup two years in a row, a feat most traced back to that trade in which the team created a stingy defense to compliment it’s offensive attack.
How does this Apply to Selling Options?
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
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. Holding adequate cash reserves is a big step in managing that leverage responsibly.
With that done properly, you can better concentrate on scoring goals. Just ask the 91’ Penguins.
* Using margin to your advantage is a key concept of commodity option selling. To learn all about futures margin and how to maximize its advantages, read chapter 6, beginning on page 79 of The Complete Guide to Option Selling, 3rd Edition. If you still don’t have your copy, you can pick it up now at our special subscriber discount by visiting www.OptionSellers.com/Book.
James Cordier is the author of McGraw-Hill’s The Complete Guide to Option Selling, 1st, 2nd and 3rd Editions. He is also founder and president of OptionSellers.com, an investment firm specializing in writing commodities options for high net-worth investors. 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. Mr. Cordier’s book, The Complete Guide to Option Selling 3rd Edition (McGraw-Hill 2014) is available at bookstores and online retailers now.
***The information in this article has been carefully compiled from sources believed to be reliable, but its accuracy is not guaranteed. Use it at your own risk. There is risk of loss in all trading. Past performance is not necessarily indicative of future results. Traders should read The Option Disclosure Statement before trading options and should understand the risks in option trading, including the fact that any time an option is sold, there is an unlimited risk of loss, and when an option is purchased, the entire premium is at risk. In addition, any time an option is purchased or sold, transaction costs including brokerage and exchange fees are at risk. No representation is made that any account is likely to achieve profits or losses similar to those shown, or in any amount. An account may experience different results depending on factors such as timing of trades and account size. Before trading, one should be aware that with the potential for profits, there is also potential for losses, which may be very large. All opinions expressed are current opinions and are subject to change without notice.
Fundamental charts courtesy of The Hightower Report, Seasonal Chart Courtesy of Moore Research Center, Inc., Price chart courtesy CQG, Inc.