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
negative camp is 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 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 position”. If you don’t do anything about it, your broker has a right and obligation to close position for you.
Additionally, a short option will never have any more dollar risk than a position in 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 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 risk in selling options lies with position size rather than strategy itself.
On positive side, selling options can put 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 short or long-term. You have to: •Choose right option to sell. •Choose right price to sell it. •Manage 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 May 66 calls and May $68 calls at a combined price of at $380us per contract.
The Right Option
By this, I mean expiry and strike. The rule for choosing 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 strike, rule of thumb here is it should be as far out of 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 market will reach strike price. At time of trade, probability of market reaching $66 was not that much greater than market reaching $63. So why not sell $63 calls for much more premium?
