Q: Why is it some advisers and brokers regularly recommend selling options while others recommend never doing it?

A: Short selling options has always been a controversial topic. There are some that think it should never be done and others that swear by it.

In the negative camp is the argument of ‘unlimited risk’. I will go so far to say a short option can have significant risk, but never unlimited risk. If a position starts losing and keeps losing, you would have to be silly or in a coma not to do anything about it. There is opportunity to close a losing position and limit a loss. There are of course some market situations where prices can gap against you or worse still market makers will not deal because of a fast market. This can mean a greater loss, but it doesn’t mean unlimited loss.

Another point to make is futures and index options are margined (meaning a deposit is required) and this margin will be adjusted every day as the market and other option price factors change. If this margin eats up all of your account balance, then you will get a call from your broker. It is a broker’s legal responsibility to make sure you option position does not lose more than what is sitting in your account. In this situation, you will receive a “margin call’ which means “inject more funds or close the position”. If you don’t do anything about it, your broker has a right and obligation to close the position for you.

Additionally, a short option will never have any more dollar risk than a position in the underlying futures or shares. Think about that. An option cannot have a delta greater than 100% or -100%, so it can never carry more risk than the underlying. So there is no greater risk than trading futures.

The key issue here is leverage. Like futures, options offer leverage. Trade too many contracts, and your losses can mount up. You could say the risk in selling options lies with the position size rather than the strategy itself.

On the positive side, selling options can put the odds in your favour and offer a high probability of profit. Note though, just because you sell options does not immediately mean you will profit over the short or long-term. You have to: •Choose the right option to sell. •Choose the right price to sell it. •Manage the trade effectively. To illustrate these points, I’ll use a recent Option1 trade. In March, when Crude Oil was just about to touch $57, I recommended selling short the May 66 calls and the May $68 calls at a combined price of at $380us per contract.

The Right Option

By this, I mean the expiry and strike. The rule for choosing the expiry is easy – choose as little time as possible. It is better to have twelve consecutive one month trades than one twelve month trade. As a rule of thumb, selling options with less than two months to expiry is preferred.

In terms of the strike, the rule of thumb here is it should be as far out of the money as possible while still returning enough premium (after brokerage) to make it worth your while.

It is always tempting to sell a lower strike price and receive a greater premium. This however would carry greater risk.

The risk in this respect is not so much in calculating whether or not the market will reach the strike price. At the time of the trade, the probability of the market reaching $66 was not that much greater than the market reaching $63. So why not sell the $63 calls for much more premium?

Well it’s all about what happens to the option price leading up to expiry. You see while the probability of the market reaching $63 for example may have been low, there is still the risk of the option price inflating to unacceptable levels based on smaller movement in the market.

The market would have only had to shoot up to $60 or $62 within a short time frame and that $63 call would be showing a significant loss. From there the market could well turn around, but you may not be able to afford to hold it that long to find out.

Holding the $66 and $68 calls gives room to breathe even when the market does not do what we want. If the market made it up to $60 for example, we would have had to adjust a trade in the $63 calls. The trade with higher strikes would not need that adjustment.

The Right Price

If you have a car to sell, you would have a fair idea of what is too low, what is fair and what is above the market. The same goes with options. You have to know what is a good price and what is a bad one.

At the time, the Crude Oil calls were sold for a good price. Analysis showed volatility to be overvalued and therefore it would be the right trade to make.

Pricing is a function of things such as time and volatility. These are factors all option pricing models use. The key is knowing how to interpret these models. Interpretation will tell you what is a good price and what is a bad one.

Effective trade management

In an ideal short option trade, there is no management required. The idea is to see the option expire worthless without the market ever getting near the strike price. Things don’t always work like that however and that is why every trade needs a plan. Generally there are three actions you can take when the premium goes against you: •One: stop the trade out at a loss and walk away. Of course this requires you to set a stop loss level, preferably before you enter the trade. •Two: roll the position. This simply means closing the existing trade and establishing a new short position with a higher strike price and/or a longer time to expiry. The key here is to decide when you should initiate a roll. It is best to agree on a price in the underlying as a trigger. For example: “If the market gets to $63, I will roll my $66 calls”. The trigger point can change as time passes since a rally of $5 today will affect options differently than a rally of $5 over the next month. Additionally, the choice of what to roll to should be subject to the same requirements as above (i.e. the right options at the right price). •Three: establish additional positions to either decrease risk or increase potential return from the total trade. One could easily write volumes on different strategies that could be implemented. However there is a simple premise here: if you want to add a position that will stand to cover any existing loss, you will be taking on extra risk. Also if you want to add a position that will hedge any further risk, it will come at a cost. It’s all a balance of risk and reward.

Now it is true you could follow all these principles and still lose money. There is risk in every trade no matter how well planned. However, following the above guidelines (as we do at wit the Option1 trading recommendations) can help move the odds in your favour.