The Three Biggest Mistakes New Option Sellers Make and how to avoid Them
When considering whether or not to allocate capital to an option selling account, many of the resources you may have access to describe the “right” way to go about selling options. Whether you hire a professional manager or attempt to go it alone, knowing what to do seems to take precedence over what not to do.
It is my experience, however, that not doing the wrong things will have every bit if not more impact on your portfolio’s ultimate performance than doing all of the right things. Therefore, this month’s Seminar will focus on the three biggest mistakes option sellers make and how to avoid them.
The Big Three Mistakes
This is number 1 for a reason. When I was working as a broker for self directed traders, I would see investors do this time and again. We’d school them on how to sell options but we couldn’t tell them how to position. So, they would sell a few options, see them decay, get excited thinking they’d found the holy grail of investments, and proceed to go crazy with selling far too many options for their size of account. They would end up with either too many options for their account or too concentrated on one or two sectors. This puts the whole portfolio at greater risk of taking losses. Option selling works but you have to understand and respect the leverage.
WATCH OPTIONSELLERS.COM’s James Cordier Explain How He Avoids Over-Positioning Portfolios on the new Seminar PageWatch Video Now
The good news is that Mistake #1 is easily avoided by basing your portfolio on the recommended structure illustrated in our portfolio pie chart. (If you are not familiar with this, it is featured in our Investor Discovery Kit available for free to high net worth investors on our website.) To review, keep 50% of your account capital in cash. Diversify your other 50% amongst at least 6-8 commodities, puts and calls, using a mix of naked and spread strategies.
2. SELLING TO CLOSE TO THE MONEY:
Many option selling “experts” will tell you that the best way to sell options is to select strikes with less than 30 days remaining until expiration. The reasoning is that you get the maximum rate of time decay. This approach may have it’s merits. But in my experience, it has one major drawback: to get any premium at all, you have to sell very close to the money. In the futures market, this can mean selling perilously close.
Avoid the trap!
Selling too close to the money is how option sellers end up with positions in the money.
You avoid this mistake by selecting options that are deep out of the money – preferably 50% or more. This means looking for markets with a little more volatility and being willing to write your options further out in time. Remember that you can sell options 4, 5 even 6 months out and still be taking profits in 60-90 days.
This places your strikes far away from the market and sharply reduces the possibility of any of your options going in the money. In the money options appreciate quickly. Staying out of the money is one key way to avoid taking a loss. It is also a good way to keep restful nights.
3. NOT HAVING AN EXIT PLAN:While most all investment books, courses articles talk about risk management, you would be surprised to learn how many traders just wing it. They get excited about entering a trade and don’t bother to think about what they will do if things don’t go as planned. When they do get a trade that isn’t working they can often experience altered judgment or worse yet, they panic and just close out their position, regardless of where the market is.
There are several effective methods of managing your risk as an option seller. (To learn what these methods are, you get an entire chapter on them in The Complete Guide to Option Selling – 3rd Edition now on sale at book retailers or at a special discount on our website www.OptionSellers.com/Book .) I’ll give you one here. The 200% rule states that when an option doubles in value from the point at which you sold it, you exit. It is hard to get in trouble with the 200% rule. This is why I often recommend it to beginners.
As a professional, I tend to incorporate more advanced risk management tactics into our portfolios. However, the 200% rule is a solid strategy and I still utilize it in our program to some extent.
The important thing to remember is that you do have some kind of exit plan in place. That way when the market or your option reach a certain level, you know exactly what to do. You are not reacting emotionally.
While these are certainly not the only three mistakes you can make as a new option seller, they are, in my opinion, the most common. Avoiding these alone will take you a long way towards becoming an effective option seller for years to come.Watch Video Now
If you are a high net worth investor and would like to learn more about selling deep out of the money options as a portfolio strategy, you do not want to miss a Free Report we have created just for you. The Option Selling Solution: How to Sell Options to Target Outsized Returns, Gain Real Diversification and Achieve Peace of Mind is a 30 page, comprehensive primer on getting started in option selling. If you currently sell options or are only interested in exploring the strategy, this starter guide is a MUST HAVE for you. Get your complimentary copy now by visiting www.OptionSellers.com/Solution.
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James Cordier is the founder of OptionSellers.com, an investment firm specializing exclusively in writing commodities options since 1999. OptionSellers.com offers managed option selling portfolios starting at $250,000 minimum investment. 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 director of Research at 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 or at a special discount through the OptionSellers.com website.
Price Chart Courtesy of CQG, Inc.
***The information in this article has been carefully compiled from sources believed to be reliable, but it’s 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.