The Three Biggest Mistakes New Option Sellers Make And how to Avoid Them
By: James Cordier, Michael Gross, OptionSellers.com
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.
James Cordier explains how YOU can avoid option selling mistakes – WATCH NOW
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
- Overpositioning: 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. 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 James Cordier Explain How He Avoids Over-Positioning Portfolios
This also goes back to the trader vs. investor mentality. Option selling can sometimes be detrimental to active traders. Traders want to (in fact, they think they have to) trade every day. Option selling is more of a passive activity that requires mostly time and patience. This puts the strategy at odds with active traders that like a lot of action.
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 available in the “7 Secrets” booklet available for free 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.
I started managing portfolios many years ago because I got tired of watching traders lose money by making mistake number one. The portfolio structure we recommend is based on many years of hard won experience. Use it and you won’t make the mistake of overpositioning.
- Selling too 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
Selling too close to the money is how option sellers end up with positions in the money
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.
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I had a client once named “Brian” (names changed to protect the guilty) who swore he had the ultimate program for selling options. For three months he sold options in a variety of markets with about 30 days left until expiration. He did remarkably well. The fourth month, he was short Live Cattle calls and Soybean puts almost right at the money. Cattle prices jumped that month, soybean prices fell. Both positions ended up in the money. To make matters worse, those were the only positions Brian had on, and they were taking about 80% of his available equity – meaning Brian was also violating rule #1. He ending up taking futures contracts to try to offset his options, tried to trade his way out of it, and of course, lost. He ended up giving back his profits from the previous 3 months.
You avoid this mistake by selecting options that are at least 50% out of the money and preferably 75 to 100% out of the money. This means looking for markets with a little more volatility and being willing to write them 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 ever going in the money. In the money options appreciate quickly. Staying out of the money is one key way to avoid taking a loss.
If you are using option selling as a serious investment with serious funds, you should approach it like a portfolio manager – not like a thrill seeker looking for action or “fun.” Selling deep out of the money keeps the action to a minimum and the time decay moving along at a steady pace.
I’ve found it makes for a more comfortable trading approach which means restful nights.
- 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.
Option selling is different than other investments in that it is difficult to draw a line in the sand and say, “if it gets here, I’m out.” That being said, the 200% rule is a good rule for beginners which is why I recommend it. It is hard to get in trouble with the 200% rule. ( For those unfamiliar with the 200% rule, we devote a full chapter to risk management and the 200% rule in The Complete Guide to Option Selling. )
I must admit that contrary to what many books will preach, I do not have an exit plan when I enter a new position. The variables with a short option make each situation different and it is difficult to make an exit plan when you don’t know what the scenario will be. However, if a position is moving against us, you better believe that we have an exit plan by the time that option doubles. Usually this involves some form of scaling back and reducing exposure, allowing us to gradually adjust our position. Managing risk on your option selling portfolio should be more like steering a large ship rather than steering a Formula 1 race car.
The point to take here is that there are several ways to manage your risk. The important thing is that you 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.
Avoiding these three mistakes alone will take you a long way towards becoming an effective option seller for years to come.
If you have questions about working with an option selling portfolio, feel free to give us a call at 800-346-1949 or request one of our option seller information kits at www.OptionSellers.com ($100,000 minimum investment).
James Cordier is the founder of Liberty Trading Group/OptionSellers.com, an investment firm specializing exclusively in selling commodities options. 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 an analyst with Liberty Trading Group/OptionSellers.com. Mr. Cordier’s and Mr. Gross’ book, The Complete Guide to Option Selling 2nd Edition (McGraw-Hill 2009) is available at bookstores and online retailers now.
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** 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.
