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Article 1: Risk
of 'Unlimited Losses' in Naked Option Selling is a Myth!
Here's a Different Way of Looking at Options The strategy of option selling has become increasingly popular with investors in recent years. For a long time, the term “unlimited risk” was enough to scare most investors away from selling options. But many are now realizing that this term can be misleading taken out of context and such a high percentage strategy should not be overlooked in a serious portfolio. The Chicago Mercantile Exchange estimates that approximately 80% of options held through expiration will expire worthless. With today’s volatile markets, many investors are starting to believe this is a statistic they would like to see working to their advantage.
Using his popular 10K Strategy, Dr. Allen made 124% in one year on Fannie Mae while the stock fell by 8%! Over 2003, again using his 10K strategy, Dr. Allen set up a $10,000 brokerage account at the beginning of 2003 with the expressed goal of doubling the account during the year. At year-end the $10,000 investment stood at an amazing $29,600 (a 196% gain!). For most traders and/or investors, the hardest part of trading is trying to determine where the market is going to move, and when. But what if a trader did not have to decide? What if he did not have to determine which way the market was going to move? What if, in exchange for giving up his chance to make a large windfall with one big move, one could free himself from the daily whims of the market and settle for making smaller, yet surprisingly consistent gains over and over? In this situation, your profits would be limited on each individual trade but your probabilities of success on each individual trade would be high. If this type of investing sounds interesting, then the strategy of selling options might be for you. In selling (or writing as it is sometimes called) options, one does not have to decide where the market is going to go. One simply has to decide where the market is not going to go. He selects a price level above or below the market that he believes the market will not reach within a certain time period (for our purposes, generally 30-90 days). He then sells an option at this price level and collects a premium for doing so. If the time period elapses and the market has not attained this price, the option expires and the investor who sold it keeps the premium he collected as a profit. The approach, in and of itself, is similar to the one used by insurance companies across the globe. Is there risk in this strategy? Yes, of course. But no more risk than in buying or selling a futures contract. And, in most cases much less. Just like an insurance company, you will have to pay out from time to time. But remember, insurance companies make hefty profits by collecting many premiums, but only paying out on a few. If you begin selling options, you would be operating this way too. This does not mean that one is immune from large drawdowns when utilizing option selling. It does mean that, statistically, the majority of your trades should be winners. Managing the risk on the losers, then, becomes of paramount importance in option selling. There are many complexities to this strategy in which one can increase ones odds even further. There are just as many strategies available to control risk. Of course, the strategy of option selling is far to complex to condense into a single article. There are so many intricacies to the approach that we’ve written an entire book on the subject (see www.optionsellers.com). However, the short explanation above is enough to grasp the general concept. For those unfamiliar with options, an option is a contract that gives the owner the right, but not the obligation, to buy or sell a specific commodity or security at a specified price. However, the buying or selling of these options is a market in and of itself. Many traders like to buy options because, for a small premium, they can gamble that the price of a specific commodity or equity will make a large move in their favor. In most cases, the market will have to move quickly and dramatically in favor of the option buyer for him to make money. Buying options is generally a favorite strategy of small, individual investors trying to take a small amount of capital and turn it into a large payload. The statistic that these speculators ignore is that it has been estimated that options will expire worthless 80-90% of the time if held to expiration. This means that the premiums buyers pay to purchase these options will be lost approximately 8 out of 10 times if the option is held through expiration. But where do these premiums go? To the sellers, of course! Selling options has been a base strategy of professional traders and commercial hedgers for years. They sell options, and small, generally lesser-capitalized investors buy them. Most of the time, the options expire worthless and the professionals and commercials take the money. This is why we recommend the strategy of selling options to our clients. In our opinion, selling options is a strategy for serious, sophisticated investors. Buying options is for amateurs. Options are traded on the open market, just like futures contracts or stocks. They can be bought and sold just as easily as buying or selling a futures contract or a share of stock. Most major futures markets also offer a corresponding option market for each contract. For instance, if one wanted to trade gold, one could buy or sell a gold futures contract, or one could choose instead to buy or sell gold options. The options, of course, are based on their corresponding or underlying market. Therefore, if one bought or sold a February Gold option, it would be based on the February Gold futures contract. There are two types of options, puts and calls. At the risk of oversimplifying the difference, buyers of calls want the market to move up, buyers of puts want the market to move down. These option buyers generally believe the market is going to move towards or eclipse a specific price level. With options, this specific price level is referred to as the strike price. An option will generally show it’s greatest increase in value after the market has moved beyond its strike price. It is for this reason that buyers of options generally need the market to make a moderate to large-scale move in order to show a profit. Most of the time, this will not happen. However, occasionally, a market will make a considerable move in favor of the investor in which case his small investment in the option can show a substantial profit. This is what attracts small speculators to option buying. Sellers of options, however, do not require the market to make a big move in order to profit. An option seller wants the options to expire worthless -- for in that circumstance, he makes his profit. And the option will expire worthless, as long as the strike price has not been reached. Therefore, unlike the option buyer, he can profit if the underlying market moves in his favor (away from the strike price), remains steady, or even if the market moves moderately against his position. As the option nears expiration, it becomes more difficult for the option to gain in value, thus benefiting the option seller. The risk to the seller is that the underlying market price moves beyond the strike price of the option. There are many ways to manage this risk. However, that will be discussed in an upcoming article. Professional traders generally consider buying options to be a legitimized form of gambling in which the option buyer will probably lose his investment, sooner or later. The professional knows that by utilizing some basic fundamental research, he can potentially profit 80-90% of the time by selling options. Of course, one should do a careful undertaking of the risks involved in option selling before deciding if the strategy is right for him. However, professionals know that that by managing their risk correctly, they can avoid loss much of the time and keep a large percentage of their premiums as profit. Professionals play the percentages. By selling options in your portfolio, you can too. The benefits and drawbacks of option selling are summarized briefly below:
If you would like to learn more about selling options in a diversified portfolio, visit us on the web at www.libertytradinggroup.com. You can also order your copy of "The Complete Guide to Option Selling" by James Cordier and Michael Gross online at www.optionsellingguide.com. James Cordier is head trader and Michael Gross is director of research at Liberty Trading Group, a full service futures brokerage specializing in option selling. Mr. Cordier’s and Mr. Gross’s book, "The Complete Guide to Option Selling" (McGraw Hill 2005) is available at bookstores and online retailers. James also writes "Commodity Option Selling" in TheMoneyBlogs.
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