Three Big Mistakes of New Option Sellers

07/05/2010 12:01 am EST

Focus: OPTIONS

When considering whether or not to allocate capital to an option-selling portfolio, 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 article will focus on the three biggest mistakes option sellers make and how to avoid them.

The Big Three Mistakes

1) Overpositioning

This is number one 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 become 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.

This also goes back to the trader-versus-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 who like a lot of action.

The good news is that mistake number one 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 “Seven Secrets” booklet available for free on our Web site.) To review, keep 50% of your account capital in cash. Diversify your other 50% among at least six to eight 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.

2) 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 reasoning is that you get the maximum amount of time decay. This approach may have its 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.

I once had a client 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, and 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 number one.  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 three months and was lucky it was not more.

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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 four, five, even six 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 you avoid taking a big loss.

I’ve found it makes for a much more comfortable trading approach, which means more restful nights.

3) Not Having an Exit Plan

While most all investment books, courses, and 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 instead of steering a Formula 1 racecar.

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 reaches a certain level, you know exactly what to do, and 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.

By the Staff at OptionSellers.com
Find out more about options at OptionSellers.com

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