Low Risk Options Trading Strategy - Option Spreads
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Hi
As I once wrote about selling option strategy's in this thread ( which is first about options spreads and not about selling options ), I would like to post here an actual article from James Cordier and Michael Gross.
I am clear, that many thing is written and I am more clear, that it has to be stressed from time to time, that we can make money with options writing and on the other hand, we can strongly burn our fingers with that, when not doing it the right way. This article stresses onces more about such mistake.
Here it goes :
Option writing mistakes to avoid !
In todays volatile and unpredictable markets, option selling is becoming a popular choice among high net worth investors and traders. This has been mainly because of the strategys high probabilities of success on individual trades, ability to generate reliable income and positive performance in all types of market conditions.
But while option selling can be a powerful way to diversify into a non-correlated, non-directional strategy, there is no free lunch. Writing options is one of those strategies that is easy to understand but infinitely more difficult to master. Option selling, especially in commodities, has its own set of risks. Knowing how to deal with them should allay any fears you may have about selling premiums and boost your bottom line.
When considering whether or not to allocate capital to an option selling portfolio, many of the resources you may have access to describe a recommended 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.
Experience shows, however, that not doing the wrong things will have as much, if not more, an impact on your portfolios ultimate performance than doing all of the right things. Therefore, we can learn a lot from the errors of others. To that end, well explore the three biggest mistakes that option sellers make and, more importantly, discuss simple ways to avoid making them.
Mistake one: Over-positioning
Over-positioning is the biggest mistake new option sellers make. Most brokers servicing self-directed clients will see this again and again. No matter how much you school them on how to sell options, it is difficult to teach somebody how to position.
Typically, this is how it works: New traders sell a few options, see them decay and get excited thinking they have found the Holy Grail of investments. They proceed to ramp their activity to ridiculous levels, selling far too many options relative to their account size and end up with either too many options for their account or too concentrated in a particular market or sector. This puts the whole portfolio at greater risk of taking losses. Option selling works but you have to understand and respect the leverage. Remember you are supposed to be right most of the time in premium selling but at some point you will take a loss and you cant let that loss wipe you out.
This also goes back to the trader versus investor mentality. Option selling can sometimes be detrimental to active traders. Traders want to (and sometimes 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.
Some simple guidelines can go a long way toward protecting against over-leverage: Keep 50% of your account capital in cash and diversify your other 50% among at least six to eight commodities, puts and calls using a mix of naked and spread strategies. This portfolio structure is based on many years of experience managing propriety and client funds. Use it and you wont make the mistake of over-positioning. While the vast majority of professional option writing managers concentrate on stock index markets, diversifying across commodities provides more variety and allows you to better take advantage of mispriced premium levels, particularly some seasonal mispricing that often occurs in certain agricultural markets.
Many option selling proponents will tell you that the best way to sell options is to select strikes with fewer than 30 days remaining until expiration. The reasoning is that you get the maximum rate of time decay (see Premium decay, right). This approach may have its merits, and it certainly looks good on paper, but it has one major drawback: To get any premium at all with this strategy, you have to sell quite close to the money. In the futures market, this can mean selling perilously close.
A typical experience goes like this: A trader will swear he has the ultimate program for selling options. For several months he will sell options in a variety of markets with about 30 days left until expiration and do remarkably well. The next month, lets say he is short live cattle calls and soybean puts almost right at the money. It is certainly not unheard of for cattle prices to jump while soybeans fall. Such a scenario could put both positions in the money. If those were the only options he has that month, meaning he was also making mistake number one, it could easily wipe out months of steady profits.
Avoiding this mistake is simple. Just select 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 or even six months out and still take profits in 60-90 days.
This guideline 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.
Mistake three: No 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 dont bother to think about what they will do if things dont go as planned. When they do get a trade that isnt working, they can often experience altered judgment or, worse, panic and overreact 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, Im out. That being said, the 200% rule is a good one for beginners. Basically, if the option sold doubles in value from the point at which you sold it, get out. True, there are times these options will ultimately expire worthless, but it is simply not worth the risk.
Of course, it is irresponsible to assume one rule is right for every position or that it is optimal for all positions to be placed with a pre-defined strategy beforehand. The variables with a short option make each situation different and it is difficult to make an exit plan when you dont know what the scenario will be. However, if a position is moving against you, you should be prepared for action long before that option doubles in value. Usually this involves some form of scaling back and reducing exposure, allowing you to gradually adjust your position. Managing risk on your option selling portfolio should be more like steering a large ship than a Formula One race car.
The point is there are several ways to manage your risk. Some writers use hard stops while others roll out positions to further out strikes and contracts. The important thing is that you have an exit plan in place. That way, when the market or your option reaches a certain level, you know exactly what to do. You are not reacting emotionally.
Succeed by not failing
Option writing is a strategy that can seem easy. Dont be fooled or become over confident. Putting the odds in your favor -- which is what you are doing when writing options -- does not protect from the spikes in volatility that often wipe out even experienced option writers. For beginning traders, whether you are selling commodity, equity index or equity options, the first step isnt to excel. The first step is to not fail. Avoiding these three mistakes will keep you in the game as you hone your option selling skills and learn the intricacies of the markets you trade. It will take you a long way toward becoming an effective option seller for years to come.
( Source : http://www.futuresmag.com/Issues/2010/October-2010/Pages/default.aspx )
Have a successful week.
DanPickUp
As I once wrote about selling option strategy's in this thread ( which is first about options spreads and not about selling options ), I would like to post here an actual article from James Cordier and Michael Gross.
I am clear, that many thing is written and I am more clear, that it has to be stressed from time to time, that we can make money with options writing and on the other hand, we can strongly burn our fingers with that, when not doing it the right way. This article stresses onces more about such mistake.
Here it goes :
Option writing mistakes to avoid !
In todays volatile and unpredictable markets, option selling is becoming a popular choice among high net worth investors and traders. This has been mainly because of the strategys high probabilities of success on individual trades, ability to generate reliable income and positive performance in all types of market conditions.
But while option selling can be a powerful way to diversify into a non-correlated, non-directional strategy, there is no free lunch. Writing options is one of those strategies that is easy to understand but infinitely more difficult to master. Option selling, especially in commodities, has its own set of risks. Knowing how to deal with them should allay any fears you may have about selling premiums and boost your bottom line.
When considering whether or not to allocate capital to an option selling portfolio, many of the resources you may have access to describe a recommended 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.
Experience shows, however, that not doing the wrong things will have as much, if not more, an impact on your portfolios ultimate performance than doing all of the right things. Therefore, we can learn a lot from the errors of others. To that end, well explore the three biggest mistakes that option sellers make and, more importantly, discuss simple ways to avoid making them.
Mistake one: Over-positioning
Over-positioning is the biggest mistake new option sellers make. Most brokers servicing self-directed clients will see this again and again. No matter how much you school them on how to sell options, it is difficult to teach somebody how to position.
Typically, this is how it works: New traders sell a few options, see them decay and get excited thinking they have found the Holy Grail of investments. They proceed to ramp their activity to ridiculous levels, selling far too many options relative to their account size and end up with either too many options for their account or too concentrated in a particular market or sector. This puts the whole portfolio at greater risk of taking losses. Option selling works but you have to understand and respect the leverage. Remember you are supposed to be right most of the time in premium selling but at some point you will take a loss and you cant let that loss wipe you out.
This also goes back to the trader versus investor mentality. Option selling can sometimes be detrimental to active traders. Traders want to (and sometimes 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.
Some simple guidelines can go a long way toward protecting against over-leverage: Keep 50% of your account capital in cash and diversify your other 50% among at least six to eight commodities, puts and calls using a mix of naked and spread strategies. This portfolio structure is based on many years of experience managing propriety and client funds. Use it and you wont make the mistake of over-positioning. While the vast majority of professional option writing managers concentrate on stock index markets, diversifying across commodities provides more variety and allows you to better take advantage of mispriced premium levels, particularly some seasonal mispricing that often occurs in certain agricultural markets.
Many option selling proponents will tell you that the best way to sell options is to select strikes with fewer than 30 days remaining until expiration. The reasoning is that you get the maximum rate of time decay (see Premium decay, right). This approach may have its merits, and it certainly looks good on paper, but it has one major drawback: To get any premium at all with this strategy, you have to sell quite close to the money. In the futures market, this can mean selling perilously close.
A typical experience goes like this: A trader will swear he has the ultimate program for selling options. For several months he will sell options in a variety of markets with about 30 days left until expiration and do remarkably well. The next month, lets say he is short live cattle calls and soybean puts almost right at the money. It is certainly not unheard of for cattle prices to jump while soybeans fall. Such a scenario could put both positions in the money. If those were the only options he has that month, meaning he was also making mistake number one, it could easily wipe out months of steady profits.
Avoiding this mistake is simple. Just select 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 or even six months out and still take profits in 60-90 days.
This guideline 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.
Mistake three: No 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 dont bother to think about what they will do if things dont go as planned. When they do get a trade that isnt working, they can often experience altered judgment or, worse, panic and overreact 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, Im out. That being said, the 200% rule is a good one for beginners. Basically, if the option sold doubles in value from the point at which you sold it, get out. True, there are times these options will ultimately expire worthless, but it is simply not worth the risk.
Of course, it is irresponsible to assume one rule is right for every position or that it is optimal for all positions to be placed with a pre-defined strategy beforehand. The variables with a short option make each situation different and it is difficult to make an exit plan when you dont know what the scenario will be. However, if a position is moving against you, you should be prepared for action long before that option doubles in value. Usually this involves some form of scaling back and reducing exposure, allowing you to gradually adjust your position. Managing risk on your option selling portfolio should be more like steering a large ship than a Formula One race car.
The point is there are several ways to manage your risk. Some writers use hard stops while others roll out positions to further out strikes and contracts. The important thing is that you have an exit plan in place. That way, when the market or your option reaches a certain level, you know exactly what to do. You are not reacting emotionally.
Succeed by not failing
Option writing is a strategy that can seem easy. Dont be fooled or become over confident. Putting the odds in your favor -- which is what you are doing when writing options -- does not protect from the spikes in volatility that often wipe out even experienced option writers. For beginning traders, whether you are selling commodity, equity index or equity options, the first step isnt to excel. The first step is to not fail. Avoiding these three mistakes will keep you in the game as you hone your option selling skills and learn the intricacies of the markets you trade. It will take you a long way toward becoming an effective option seller for years to come.
( Source : http://www.futuresmag.com/Issues/2010/October-2010/Pages/default.aspx )
Have a successful week.
DanPickUp
AW, this is my first options trade. I have a bearish view on the Nifty hence I would like to initiate a Bear Call Spread as follows:
50 Short Call 5900 28-Oct 158
50 Long Call 6000 28-Oct 91
Max Profit on Expiry: 3350 (Nifty closes below 5900 on Expiry)
Max Loss on Expiry: 1650
Please let me know if the above is correct. What do you think of this strategy in the current circumstances especially considering that expiry is very close?
Your insight would be much appreciated.
50 Short Call 5900 28-Oct 158
50 Long Call 6000 28-Oct 91
Max Profit on Expiry: 3350 (Nifty closes below 5900 on Expiry)
Max Loss on Expiry: 1650
Please let me know if the above is correct. What do you think of this strategy in the current circumstances especially considering that expiry is very close?
Your insight would be much appreciated.
Hi trader_man
Have not seen AW10 for weeks.
Your bear call spread is itm and atm. So, every move Nifty makes will have a significant impact on your spread.
As the life of the chosen options is very short, time value is very strong.
Sounds fine to me till a certain point. This point is : What is your adjustment plan when market goes against you ?
Do you have such an adjustment plan, which is part of every option trade or you just calculate your loss and say, that is it ?
DanPickUp
Have not seen AW10 for weeks.
Your bear call spread is itm and atm. So, every move Nifty makes will have a significant impact on your spread.
As the life of the chosen options is very short, time value is very strong.
Sounds fine to me till a certain point. This point is : What is your adjustment plan when market goes against you ?
Do you have such an adjustment plan, which is part of every option trade or you just calculate your loss and say, that is it ?
DanPickUp
Dan, thanks for your answer.
My exit plan is to wait till expiry hoping that Nifty will close below 5900. If Nifty crashes before expiry, then I will take profits. I am not keeping stop loss as I have no problem losing Rs.1650/ which is max loss. What do you think?
Also, can you explain what margin I will have to pay. In India, brokers treat each option individually. They don't consider net position. So, lets assume that Nifty closes at 5900 tomorrow. What margin will be deducted?
Thanks.
My exit plan is to wait till expiry hoping that Nifty will close below 5900. If Nifty crashes before expiry, then I will take profits. I am not keeping stop loss as I have no problem losing Rs.1650/ which is max loss. What do you think?
Also, can you explain what margin I will have to pay. In India, brokers treat each option individually. They don't consider net position. So, lets assume that Nifty closes at 5900 tomorrow. What margin will be deducted?
Thanks.
Hi trader_man
If this is fine for you, then that will be ok.
I personal like to have an adjustment plan, as I do not like loosing any money.
A very simple adjustment plan is : If market turns against you, then you also flip your positions.
You then would go long the 5900 call and you would go short the 6000 call.
Your question about the margin has to be answered by an option trader, which has an account in India. As I trade outside India, I can not answer in detail this question.
My broker in the states lower the margin for spread trades, when he is clear, that this is a spread. To make him clear about that, I can place such orders in the platform or I call him and tell him, what legs belong to each other in the account or he also get clear about that, when I ask him on the phone for the bid ask for a certain spread.
DanPickUp
If this is fine for you, then that will be ok.
I personal like to have an adjustment plan, as I do not like loosing any money.
A very simple adjustment plan is : If market turns against you, then you also flip your positions.
You then would go long the 5900 call and you would go short the 6000 call.
Your question about the margin has to be answered by an option trader, which has an account in India. As I trade outside India, I can not answer in detail this question.
My broker in the states lower the margin for spread trades, when he is clear, that this is a spread. To make him clear about that, I can place such orders in the platform or I call him and tell him, what legs belong to each other in the account or he also get clear about that, when I ask him on the phone for the bid ask for a certain spread.
DanPickUp
I assume that if I flip, I would have to close all positions and take new positions. But, if market goes against me and I flip the positions, and again the market goes against me, then I again would have to flip. The brokerage would be significant in this case. Given that Nifty is extremely volatile these days, this could be tricky to do.
Hi trader_man
If you flip, you buy back the sold one and you sell the bought one.
You also can reduce the amount of options, means that you scale out from your position.
If you always would have to flip, then this would be any way a side way market and your first spread then would have been placed on the wrong strike level.
The question also would be: In what time frame would you get your signals which would show, that you have to flip your position ?
If it would be on an intra day level, your adjustment level range would be to small and you would have to widen this range.
If there is a side way market, you can use other strategies to trade that.
Your comments about the brokerage are true. Any time you give any order, we have to pay this
commissions. So be sure to have a broker with very little commissions. Some charge, depending on the amount of options you trade per month and as bigger your amounts of trading orders are, as less cost you have.
DanPickUp
If you flip, you buy back the sold one and you sell the bought one.
You also can reduce the amount of options, means that you scale out from your position.
If you always would have to flip, then this would be any way a side way market and your first spread then would have been placed on the wrong strike level.
The question also would be: In what time frame would you get your signals which would show, that you have to flip your position ?
If it would be on an intra day level, your adjustment level range would be to small and you would have to widen this range.
If there is a side way market, you can use other strategies to trade that.
Your comments about the brokerage are true. Any time you give any order, we have to pay this
commissions. So be sure to have a broker with very little commissions. Some charge, depending on the amount of options you trade per month and as bigger your amounts of trading orders are, as less cost you have.DanPickUp
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