Our resident options experts, James Cordier and Michael Gross, answer readers’ questions.

Q: How do I manage my risk on an option-selling portfolio?
A: One of the most common questions I get from clients starting their option-selling portfolios is, "How do we manage our risk (protect our downside, limit our exposure, etc)?" It is not just a fair question; it is probably the most important question you can ask. In an investment where, statistically, 85 to 90 per cent of your trades should be winners, at the end of the year your results will depend heavily on how you handle the other 10 to 15 per cent.

Managing risk or handling losing trades is not something you should have to worry about. There are simple, effective ways to manage risk with short options. All that is required is a plan.

Risk management: laying the foundation
As in most areas of life, an ounce of prevention is better than a pound of cure. This applies to managing risk in your option-selling portfolio. How you structure your portfolio can have a big impact on your exposure. If your portfolio is structured correctly from the start, managing risk on individual positions becomes easier. To review:

• Fifty per cent of your portfolio should be held in cash. This gives your account a large cushion to absorb any potential margin increases in your positions.
• The remaining 50 per cent should be diversified over six to ten uncorrelated commodities markets. If a position should run on you, it will encompass only a small percentage of a portfolio structured this way.
• Sell options deep out of the money. This allows you to manage risk based on the value of the premium without worrying about when or if your option will get assigned.

Risk management 101: the buyback
Assuming that you are structuring correctly, we now arrive at the answer to the question everybody asks: Where do we get out?

Before I answer, let’s include some of the related questions that come with this so we may address them all at once: What if we get assigned? Do we offset with a futures position if it goes in the money? How much would we risk on each position? What is the ‘rule’ about exiting?

Investors like hard, fast, solid rules. They like things quantified. They want to know exactly what to expect. Unfortunately, investments are not like that. It is a good idea to have rules for any trading plan. However, add too many rules and your approach becomes inflexible and, ultimately, ineffective, unable to capitalize on moving opportunities.

Because of this, I like to call my trading rules ‘guidelines’. My guideline is this: If the option doubles in value from the point at which you purchased it, buy it back. Exit the position. This is known as the ‘200% rule’. Do not try to ‘delta neutralise it’ or offset it with a futures contract or anything else. In my opinion, the best approach is a simple one. The option doubled. You were wrong. Get out. Move on. Follow the guidelines laid out above and you should be able to recapture that premium somewhere else.

Our portfolio strategy sells only deep, deep, deep out-of-the money options – those that are not going to go into the money (at least not for a long, long time). This allows you to manage risk based on premium value. There is little concern about where or when it will go in the money or if it will be exercised. It’s too far away. Again, simplicity. That is the guideline I suggest if you trade on your own.

Advanced risk management
Do I always follow the 200% rule in the portfolios I manage? No. I use it as a guideline – a hazard light, if you will, to let me know that I need to address our exposure. In deciding when and if to fully or partially exit a position, I also take the following into consideration:

• How long until expiration?
• How large is this position in regard to the overall portfolio?
• Is it hedged? If it’s a call, do we have puts on the other side of the market?
• Wildcard – what is causing this to move against us and is it likely to end soon?

I would call these four questions ‘advanced risk management’ questions because I would not recommend them to a beginner or even a moderately experienced option seller. They are for the highly experienced trader, because how they are used almost always depends on judgment. And that kind of judgment takes time to develop. Nonetheless, if an option we’re holding doubles, it’s a pretty safe bet that our investors are at least scaling back the position in some way. If you are selling options in your own portfolio, it is my opinion you would do well to follow the 200% rule at all times.

Q: I’ve heard that seasonal tendencies can play a big role when selling commodities options. Do you recommend taking seasonal tendencies into account when considering a new option sale?
A: Seasonal tendencies have their drawbacks. Past performance is not indicative of future results. Season tendencies are just that, tendencies. This means prices tend to move in a certain direction during a certain time of year. However, there are no guarantees as to at what point in that time prices will move, how far they will move, or if they will move at all. There are no promises that prices will not spasm sharply in the opposite direction, right before aligning with a seasonal tendency.

Although season tendencies have their limitations, it is my guess that the difficulties of seasonal analysis are more of a problem for futures traders than for option sellers. Futures traders have the burden of having to pick market direction with nearly perfect timing.

This makes trading futures contracts in line with seasonals difficult. For option sellers, however, seasonal analysis can be a powerful tool. Option sellers are not burdened with the responsibility of perfect timing, they can withstand short-term moves against their position and they are more than willing to wait for a move to occur.

After all, they have all the time in the world. We often consult seasonal tendencies when considering positions for our portfolios. Just don’t always take them at face value. It helps to know the fundamentals driving these tendencies. Tracking fundamentals can improve your performance dramatically.

Q: Do you recommend using technical indicators for the underlying contracts when considering option sales?
A: Technical indicators can be useful when timing a trade. However, we would not suggest basing an option sale solely on a technical setup. We place more emphasis on the fundamentals of the underlying contract.

Eventually, prices will have to reflect the fundamental factors of any given commodity. Many traders and even brokers use technical analysis as their sole means of trading, simply because they don’t know the fundamentals, or they don’t have access to the resources that are necessary to gain timely, relevant fundamental data. Learning the fundamentals of a market and how they can affect price can be time consuming and difficult. However, trading solely on a technical basis is like trying to hit a baseball with one eye closed: your perspective is going to be off.

Markets can experience impressive looking breakouts to the upside or downside, but without the corresponding fundamentals to support such a move, a sustained trend is highly unlikely. Often, a chart breaking out in defiance of clear-cut fundamentals can be an excellent option selling opportunity, because many traders will tend to buy calls or puts in the direction of the breakout, driving premiums disproportionately higher.

A good example was natural gas, earlier in 2010 (figure 1). Plenty of media pundits were touting it as a great buy – great ‘value’. The problem was there was a glut of natural gas in the United States and more being added. It was oversold for a long time and bottom pickers kept trying to buy it. Markets don’t generally rally with fundamentals like that. Yet, as an option seller, you could have sold calls at more than double the value of the underlying natural gas contract on the NYMEX. That’s using fundamentals and option selling!

Located in Tampa, Florida, James Cordier and Michael Gross are portfolio managers with LibertyTrading Group/OptionSellers.com, one of the first global futures firms to specialise exclusively in selling options. Mr Cordier’s and Mr Gross’s commodities and option market analysis is featured by several international financial publications and worldwide news services including The Wall Street Journal, FOW, Yahoo Finance, CNBC and Bloomberg Television News. They are authors of ‘The Complete Guide to Option Selling’ 2nd edition (McGraw-Hill, 2009). They can be reached through their website at www.OptionSellers.com.

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This article was originally published in the Jul/Aug 2010 issue of YourTradingEdge magazine. All rights reserved. © Copyright 2011, Your Media Edge Pty Ltd. 
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