The 3 Best Ways to Manage Your Option Selling Risk
Hi, this is Michael Gross of OptionSeller.com here with your bi-monthly Option Seller Email Lesson. The lesson of this week is Managing Option Selling Risk. Probably no subject do we get more questions on via email, people responding to our articles, etc. is how do I manage this risk? Risk in option selling is the elephant in the room. It’s got to be addressed if you’re selling options, stocks, or commodities. Knowing what your risk is and knowing how to properly manage it is paramount because the big knock on option selling is, “Michael, I’m doing great. I’m selling options. I made money 3 months, 6 months, 9 months in a row.
Then what happens? One big downturn in the market and it came on and took all my profits in one move.” That’s always been a knock on option selling, and what we’re going to talk about here today is how you properly manage the risk and hopefully prevent that from happening. So, that’s something that you need to know. Obviously, if you have read The Complete Guide to Option Selling you know we talk about risk extensively in there. There are two basic aspects of option selling risk. One is overall portfolio risk and that takes into account subjects like managing your margin, position size, diversification, those type of things. That’s for another day. What we’re going to be talking about today is individual position management. It’s typically the first question people ask because they’re not really familiar with the overall portfolio management aspect. Today we’re going to talk about that initial subject.
Individual position management of an option sale does not have to be difficult. I think one of the reasons people have difficulty getting their arms around option selling is because they look at it and they think, “Well, boy, there’s a million different ways I could play this. There’s a million different things I could start doing if the market starts moving against me.” Yes, that’s true, the problem is looking at too many choices is where people get confused and get themselves into trouble. What we have found, the best way of managing risk in selling options is keeping it simple. I’ll show you what I mean. We’re going to go to our typical price chart here. Here’s your price chart and somebody said, “All your charts every week look the same” but they work for example purposes. We’re going to call this, let’s say this week we are trading coffee. You’re bearish coffee, you think things are going to go down. So, you sell a call up here and you collect $600, for instance. All you need is for coffee prices to stay below that level and you make your premium.
Well, you were wrong and all the sudden, not all of the sudden, but there’s a drought in Brazil and all of the sudden there’s a trucking strike and a combination of factors. Here’s your coffee and it doesn’t go down, it just keeps going up. Each day it goes up you’re saying, “What should I do? What should I do?” And you’re thinking, “Well, maybe if it gets here I should just buy a futures contract there, that way it will offset all the risk above that and then when it gets up here I can take the profits on the futures contract and then I can close this out.” It starts getting pretty complicated there because once you’re in a futures contract and this thing’s going up and down, that’s exactly what you’re trying to avoid with option selling. “Where do I get in? Where do I get out? What’s the chart say”, and all of the sudden you’re up at night trying to worry about what you’re going to do about your futures position in your short option. Okay? We don’t’ want any of this. Option Selling should be a longer-term, more passive type of investment. You should be sleeping at night, you shouldn’t be thinking about it. If you’re thinking about positions and what am I going to do tomorrow, you’re not doing this right, so you need to change your approach. Let’s go back to our example. Here’s your short option, you sold it at $600.
There’s three basic ways that we recommend managing risk, and, actually, there’s only one basic way we recommend to investors that are new to either selling options or new to commodities. But your three basic ways that you can manage risk that we would recommend to you… the first one, and this is mainly for aggressive investors or if the auction is getting close to expiration, and I’m going to list these here, the number one is you risk it till it’s in the money. So, what you’re basically saying at this point is, “I’m going to ride this thing out because I don’t think it’s going to get here.” Whether the thing goes here, or here, or here, or here, or wherever, I’m holding my option because I know, come expiration day, if it’s below there it’s going to expire worthless.
That’s a fairly aggressive way to approach selling options. You can do it if you’re a fairly aggressive investor, you certainly can, but the problem is if it gets here and then it keeps going you could be paying up pretty well to buy your option back. So, we typically don’t recommend this unless the option is close to expiration. If you’re down a couple weeks to expiration and the market’s flurrying right here, okay, that’s something that’s a possibility. Other than that, it’s typically not something we would recommend and typically not something we would do. In certain situations, it can be effective.
Number two way to manage your risk in options, you manage your risks based on the chart. Let’s say back in 6 months ago, there’s a strong level of resistance right here. This is just an example. There could be a number of different reasons why you pick a certain point in the chart. A chart based risk management, more or less, says, “I’m going to hold this option unless this resistance is violated. So, as long as it stays below this key resistance line in the chart, I’m going to hold my option, no matter what the value of it is, because I don’t think it’s going to break there. If it does break there and I’m wrong I’m going to get out.” That can be an effective way to manage risk on option, not all the time, but certainly some of the time, some people like to do it that way. Occasionally, we’ll do it that way, it just depends on the market and what’s going on and how much time’s left on the option. I’m just using this as an example, there are a number of technical reasons you could choose to exit a position, I’m just using a resistance line as one of them.
The third way is a premium based approach. I’m going to put a big star there. This is the way we are typically managing risk in option portfolios, not always, but most often. It’s also the way I recommend to most individual traders if you’re selling options. You use a premium based model for deciding when to get out of your option. Now, what do I mean by premium based? I mean that you’re watching what the premium of the option does. Now, obviously in an option, as time goes on, time value should gradually erode the premium of that option, but there are some things that could go on in the meantime that could make the price of the option go higher. One, of course, is volatility but, in particular, volatility when the price is moving toward your strike.
The great thing about premium based risk management is it’s a good way to keep yourself out of trouble when you’re selling options. If you’re risking and the market’s getting up here close to the money, there’s a lot of things that can happen and all of a sudden you can take a loss, sometimes one you don’t want to take. Premium based risk management means that, “Okay, I sold this option for $600 and I’m going to hold that option, for instance, until the premium, let’s say, doubles. So, if something happens in this market and I’m wrong, the volatility surges, the price surges”, all of the sudden there’s a weevil discovered in the coffee fields of Brazil that’s going to destroy half the crop, it doesn’t matter to you because you don’t care what happens. If the premium of this option gets to $1,200, you consider that a stop point. I’m getting out. I don’t care why. I’m getting out.
That’s the way I would recommend you manage option selling risk as an individual investor. Now, does it always have to be double premium? No, a more aggressive sometimes can risk to triple premium, especially if you’re writing a strangle and you have options on the other side of the market. Do we always risk the double premium? This is a big question, because we talk about the 200% rule in the book and a lot of people say, “Well, that’s how you manage risk. You manage it until the premium doubles.” No, that’s not always how we manage risk. We use often premium based, sometimes we’ll use one of the other two. We don’t always risk until it doubles, sometimes we might risk until it triples, sometimes we might risk until doubles and a half. It all depends on the market, what’s going on, the fundamentals, and everything else.
As an individual investor, especially one that is not familiar with commodity options or commodities and you’re doing this on your own, I recommend you use the 200% rule, which is you risk to double premium. That’s what I would recommend to you. So, that’s something you keep in mind. It’s a good way to keep you out of trouble. Obviously, I should mention, this works just like a stop and we do not recommend actually entering stops into your actual platform if you’re trading this at home, at least not in options. It’s just not something we found sometimes doesn’t work in your favor because if you have a stop sitting there, other traders might not want to go down that road.
I recommend, for option premium, you keep these as either in-house stops on your own system. I don’t like to say mental stops because I typically don’t recommend mental stops to investors, but keep them internal, on your internal computer on your internal platform, but honor it. If it gets triggered, you want to get out at this premium level, the premium level you’ve previously determined prior to anything going on in the market, because if you just sell your premium and say, “Well, I’ll decide how I to get out when the time comes.” Well, guess what? When the time comes, the market is all over the place, you’re emotional, you’re watching what’s going on in the market, you don’t have a plan at that point, you’re trying to decide while you’re in the middle of that emotion. That is not the way to trade, that’s how you end up losing money, so you want to decide when you go into this trade what you’re getting out at. Here’s my stop point, that’s where it is, that’s what I’m risking. Yes, it can trade through there. There’s nothing to say that you walk in one morning and the option value is higher than this, which at that point you could get out, of course, but most of the time that’s going to take pretty good care of you.
I hope you’ve found this lesson helpful on managing your individual position risk in selling options. If you would like more information on working directly with OptionSellers.com in a managed portfolio, one thing I do recommend to you is our Investor Discovery Kit. This is the kit. It explains to you all about our option selling program for high net-wroth investors, how you can participate, account minimums, and that type of thing. Also, it comes with a full-length video DVD of James Cordier’s seminar to high net-worth investors. If you’re thinking about possibly giving us a call, maybe seeing how we can work together, I do strongly recommend this pack. I think you’ll find it helpful. I hope you’ve enjoyed this week’s edition of The Option Seller Email Lesson. Have a great month of premium selling and we’ll see you next time. This is Michael Gross of OptionSellers.com.