The Complete Guide to Option Selling, Second Edition

Editorial Reviews. From the Back Cover. Option-writing strategies for high returns in every type.
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• The Complete Guide to Option Selling, Second Edition, Chapter 1 - Why Sell Options
• Reward Yourself
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However, since Mary does not want to tie up the capital necessary to short the stock, nor does she think that the stock will fall drastically, she believes that her best alternative is to sell a call. Her margin requirement is calculated in Table 4.

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Margins on futures options are determined quite differently. SPAN is a formula set by the exchanges and is based on the time value left on the option, the amount by which the option is in or out of the money, and the volatility of the underlying contract. However, attempting to explain the exact calculations for how it is determined, we feel, would be fruitless.

Most brokers and brokerages that are optionselling friendly will be able to provide you with this at your request. After a few months of selling options, you should be able to estimate the approximate margin of selling options in the futures contracts with which you are familiar. However, if you would like to obtain a copy of the software you can contact the CME or visit its Web site at www. There are still some brokerages that, for whatever reason, do not use SPAN margin and instead charge the full margin requirement for a futures contract to sell an option on that contract.

The days of large brokerage houses treating their clients like ignorant children are over. SPAN margin has allowed individual investors to obtain a much higher return on invested capital than if they had to provide a full futures contract margin to sell an option. In stocks, the formula remains the same throughout the life of the option. This assumes, of course, that Mary wishes to remain in the position.

Her new margin requirement would look like Table 4. Calculations such as this are used by non-option sellers to dissuade potential option sellers from employing the strategy. It ignores the fact that Mary could have exited this position at any time and, as an intelligent trader, would have done so long before the price moved this far.

Margin requirement for selling a futures option works differently. Your margin requirement will be based on the size and volatility of the underlying contract, the distance the option is out of the money, and the amount of time left on the option. The following example illustrates margin with futures options. Trader Mary is bullish on crude oil. She knows the market can make sharp swings downward, however, and therefore decides that instead of buying the futures contract, she can sell a put several dollars below the market. Her out-ofpocket margin requirement is calculated in Table 4.

The same factors that affect the value of the option can affect its margin requirement. How much cannot be calculated precisely because other factors, such as time value and volatility, will come into the SPAN calculation. The delta of the option comes into play here when measuring volatility. However, most individual investors do not have the time or the willingness to sit around and calculate how the delta of the option will affect their margin requirement on their option should it move one way or the T A B L E 4.

We generally recommend that new or conservative traders keep up to 50 percent of their account available as backup capital. The exception to this rule would be if the exchange decides to raise minimum margin requirements for the underlying contract itself. In this case, the margin to hold the option would increase by a corresponding percentage. In other words, if the value of the option is deteriorating, the trader does not necessarily have to wait until expiration to use the premium he collected from the option sale. It gradually becomes available to him as the option deteriorates. While stock option trading can offer excellent returns for patient investors, returns from selling futures options can dwarf their counterparts in stocks, assuming that the trader is willing to assume a bit more risk.

However, if you are reading this book, it is probably safe to assume that your investment tendencies tend to lean to the aggressive side, at least for a certain portion of your portfolio. This increased risk does not come from increased volatility in commodity prices. Studies have shown that, historically, stock prices are actually more volatile than commodity prices. A trader who knows how to control and take advantage of this leverage while remaining respectful of it can reap handsome rewards. Selling futures options, if it is done correctly and not recklessly, is simply taking a very conservative approach to a very aggressive investment.

Although this book is about teaching traders how to sell futures options, it is also about showing stock option traders a new, potentially more potent avenue for expanding their option investments. Nonetheless, the key advantages and disadvantages of both types of options are now explored. Assuming that this is the case, this would equate to a 14 to 17 percent return on capital invested. This difference can be more exaggerated in higher-valued options, which we recommend generally. Another advantage is higher premiums for distant strikes.

Because of the leverage available in futures, attractive premiums can be collected for options with far-out-of-the-money strikes. While some more distant premiums are available in certain volatile stocks, most options in equities must be sold within one to three strike prices of the actual underlying stock to receive any premium at all. In some markets with more volatile natures, options sometimes can be sold at strike prices that are double or even triple the price of the underlying contract.

Think about this for a moment. Coffee prices would have to increase by to percent within the life of that option for it to ever go in the money. This strategy can be very lucrative for traders willing to assume the risk of potential increases in margin in the meantime. While there are many hundreds of stocks where options may be available for active trading, there are only about 50 to 60 futures contracts with an active option market. This provides a more concentrated market for options in futures. Therefore, the typical futures contract is likely to have much more liquidity in its option market than most stocks.

Leverage is a double-edged sword, and while gains can be much higher in selling futures options, so can losses. However, the value of his option and his margin requirement can increase substantially more in an adverse move in the underlying commodity. In addition, if each option gets exercised and the market keeps on falling, the risk becomes more pronounced. The stock option seller is long XYZ stock from These examples really only illustrate the differences in leverage between stock and futures trading.

They do make the assumption that neither trader simply decides to buy back his option when the market moves against him. We are not bashing equity options. Many investors have achieved substantial returns with a properly managed option selling approach in equities. Gaining substantially higher leverage can carry an increased risk in some situations but at the same time provide for substantially higher returns in an option portfolio. Selling options randomly may result in about 80 percent winners, but one or two in the 20 percent of losers could end up with substantial losses.

This is why a trading plan is important when selling options. By employing the strategies discussed in this chapter, traders not only can potentially increase the percentages of their options expiring worthless, but they also can better their odds that their winners do not move sharply against them in the meantime.

The goal of selecting the right market, the right strike price, and the right month should be to pick options that will provide a smooth, steady ride to zero at option expiration without the dramatics in 67 68 PART II Option Selling Strategy and Risk Control the meantime. A properly managed option writing portfolio should allow its owner to sleep well at night, should be low maintenance, and should be predominantly absent of heart-pounding, gut-wrenching decisions.

Many new traders erroneously believe that this can only be accomplished through writing covered spreads. This is not true. While writing naked options may sound out rageously aggressive and even frightening to some, if it is done correctly, one should be able to sleep very well at night. A successful option seller has no need to sit in front of a screen all day. In fact, many successful sellers of premium with whom we have worked may only check option prices once a day, once a week, or even once or twice a month.

If you are trading options completely on your own, checking your positions daily is probably a good idea. If you are working with somebody you trust to monitor your positions, you may not need to check as often. Buyers of car insurance pay insurance premiums to an insurance company to insure their vehicles. They pay these premiums month after month.

If a driver does happen to have an accident, the insurance company must pay up. An insurance company tries to weed out drivers that it deems to be prone to accidents. Some of these may get insured at higher premiums to account for the higher risk the insurance company is taking on them , and some may not get insured at all. Your job as an option seller is to go through this exact same process. Just as most drivers do not have accidents, most of your options will never go in the money.

However, as in insurance, a few bad accidents can be bad for the bottom line. An insurance company, therefore, tries to reduce the chances that one of its drivers will have an accident by checking a number of factors such as driving record, age of the driver, type of car, etc.

The Complete Guide to Option Selling, Second Edition, Chapter 1 - Why Sell Options

While an insurance company can in no way guarantee that the drivers it selects will not have accidents, it CHAPTER 5 Strike Price and Time Selection 69 certainly can help its business by selecting only drivers who have what it considers a low chance of being in an accident. In doing this, we are by no means suggesting that this is the only way to sell options successfully. There are as many option strategies around as there are traders. We are merely suggesting this approach for the fact that it is the one that has performed most consistently for us and our clients over the years based on a combined 30 years of futures and option trading experience.

In that time, we have managed, either in personal or client accounts, to employ just about every kind of option strategy you can imagine. Therefore, we are not going to discuss the many ways a trader can sell options. While we are going to review recommended option spread strategies in Chapter 7, this strategy will be all you need to get started in selling options effectively. Just because you sell it naked does not mean that you have to hold it naked. Although this can be a very productive approach, we also will be discussing how more conservative traders can turn their naked option sale into a covered position in Chapter 9.

But we will treat a covered position as a risk-control method and discuss it at length under that heading. This chapter is about the selection and selling of the right options, regardless of whether they are naked or covered. Again, this is not to be taken as the Holy Grail of option trading. It is simply an approach that has worked very well for both of us over the years and, if employed correctly, hopefully can work well for you.

If managed correctly, many of the risks can be effectively minimized. In a nutshell, this simple strategy is outlined as follows: Select markets with very clear long-term bearish or bullish fundamentals. Sell options with two to six months of time value in favor of these fundamentals at distant strike prices.

Set a risk parameter on each option that you sell and sit back and wait. It sounds very simple, and it is. However, simple does not mean easy. There are a number of factors to study and consider to give yourself the greatest odds of success. These will be the basis for this chapter. Technical traders may argue this point, but consider the logic. However, long-term and sustained price movements are caused by the underlying base fundamentals of a particular commodity.

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Often, technical moves will occur in outright contradiction to the long-term fundamentals. This is why fundamental traders historically have had a hard time trying to trade the market, at least on a short-term basis. How many traders ultimately are right about the market and still lose money? I knew the market was heading higher. We all knew it was going higher. So what did you do, John? The market went up, way up! I lost a little money. Then it went up.

Most likely either professional or commercial traders. They probably were watching the same fundamentals and technicals as John and were either better at timing it or had the resources to ride out the short-term move against their position. They ultimately have more resources available to them than John. They do this for a living, all day long, every day. John may be very good at what he does and may be very intelligent and very dedicated to his trading. When push comes to shove, John stands little chance trading from his computer in his spare bedroom with the few spare hours he has each week.

Even if John is retired and has all the time and money in the world, unless he is willing to dedicate his entire life to trading, spend years and countless dollars and resources on becoming a professional trader, his chances of success against these heavyweights over the long term are very slim.

What if, instead of beating them, John joined them? John could give up trying to duke it out with the pros in the futures pit and take a big step out of the chaos and into a favorite strategy of the very traders with whom he was competing. The odds are too low. We believe that markets can and do move somewhat randomly on a short-term basis. This is why you will sell two to six months out. Selling with this much time value on your options will allow you to sell at strike prices far enough out of the money that your position may not be greatly affected by short term aberrations in a market.

But he would have made money, probably good money, based on his initial insight. The short-term move down would not have stopped him out, nor would it have scared him out of his position if proper risk management rules were followed. The market may move lower short term and then proceed higher.

John learned to stop trying to outguess what the market is going to do over the short term. Nobody can do this consistently, not even the pros. As stated earlier, markets can move at random over the short term. There are too many variables that can sway daily prices, such as media reports, fund deciding accumulation or liquidation on a given day, and even just the general mood of traders on a given day or week.

The option seller is freed from these short-term concerns and can focus wholly on the bigger picture of supply, demand, and long-term price trends. In other words, such an investor can focus on the fundamentals. But what are fundamentals, and how does one track them? Fundamentals are the overall factors of supply and demand that affect the price of a given commodity.

If you want to learn what moves the price of soybeans will make, learn where they are grown. Learn who the largest producers are so that you can pay attention to their crops and supply situations and not be distracted by media reports from smaller producers. Learn what countries import these commodities and how much they use. Focus on key importers and overall world numbers. Again, we do feel that technical trading has its place in option trading and do use technical indicators extensively in the timing of option trades. But the timing of a trade is more of an optimizing tool and not as important in option selling.

Technical traders, however, can use options very effectively in their approach as well. The same selection process and risk parameters can be used just as easily, and option sales can be substituted for futures contracts to provide a more conservative approach with a much larger margin for error.

Some markets have so many different fundamentals that change so quickly that a trader may want to give longer-term technicals a bit more weight. Markets such as currencies and interest-rate futures are two examples of markets where knowing the fundamentals may be less of an advantage than in a commodity such as wheat or natural gas. Take some time to explore www. The exchanges also offer a wealth of fundamental information.

Their Web sites can be found in the Resources section at the end of this book. While it is always a good idea to have some basic understanding of the market in which you are trading, good brokers should spend their time researching these data and mining this information for you. Especially good brokers will not only save you a great deal of time but may be able to make a recommendation based on these data that actually will make you some money. This will save you countless hours of research and years of study and can make your option selling decisions much easier.

However, good brokers are not necessarily good traders, and vice versa. These include such commodity contracts as corn, soybeans, coffee, sugar, cotton, crude oil, natural gas, and copper, among others. We have devoted Chapter 11 exclusively to the basic fundamentals of commodities and have designed it to serve as a primer for you in becoming familiar with some of the general facts you should know and follow in regard to each.

In the meantime, the lesson is: If a friend or relative asks why you are in that market, you should be able to give a two- to three-sentence summary that explains your rationale for being in the trade not that it is any of their business. While selling options in any market gives you favorable odds, selecting the right markets in which to sell premium can boost your odds and your returns substantially. Seasonal tendencies, or seasonals for short, use historical records to 76 PART II Option Selling Strategy and Risk Control graph the tendency for certain markets to move in certain directions at certain times of the year.

While these tendencies are often very reliable, their exact timing and magnitude of movement are an inexact science at best. Seasonal tendencies are mostly the result of certain fundamentals that take place in a particular market during a given period during a year e. Seasonals and how to use them effectively will be explored in more detail in Chapter For now, make a note to be aware of the seasonal tendencies of a market in which you are considering selling options.

Know the fundamentals behind the seasonal tendency, and analyze how they could affect prices of that commodity this year. While most traders do not know how to use seasonals correctly, you are going to learn how. You also will learn how option selling combined with seasonal tendencies can be a very effective strategy.

Seasonals can be powerful tools in your arsenal of option selling weapons. As we mentioned earlier, one of the main knocks on option selling is the unlimited risk factor. If you are selling at-the-money or close-to-themoney options, this risk is much closer and is much more immediate than it is if your strikes are considerably farther away from where the market is trading. Many option traders are tempted to sell only options with less than 30 days left until expiration.

They do this because, all other things being equal, an option will show its maximum time deterioration within the last 30 days of its working life. While many option sellers swear by this approach, the downside is that to collect any worthwhile premium, the trader must sell at strike prices perilously close to the money. What does this mean? As long-term fundamental traders who want to make money and sleep at night, this is exactly what we are trying to avoid.

The trader must sell options with moderately more time value than her quick-trade counterpart. However, if she is competent in her analysis of the market, she can use this to her advantage. This allows the market plenty of room to move and allows the trader plenty of room to be wrong—and still make money. In essence, such a trader can overcome the short-term plays and technical moves against her long-term view of the market.

Such a trader forces the market to make a long-term, sustained move against its core fundamentals in order to make her a loser. She still stands a good chance of making money. Remember, the market does not have to move in the direction that most favors the trader. It can move sideways or even against the trader for a while, and the option can still expire worthless if the market does not reach her strike. First of all, if the market has made a large move up or down, there is probably a very good fundamental reason behind it.

Find out what it is. Is it something that is permanent and cannot be changed in the near future e. Second, did the market make this move in a rapid, violent explosion or collapse, or did it achieve its current price level as a result of a steady, continuing trend? These can be fertile grounds for sellers of options.

The upside to this is that the market volatility can drive option premiums outrageously high and often make them extremely overpriced. This can be a very lucrative time for option sellers. The downside is that the market will remain vulnerable to additional volatile moves in either direction, meaning that even your far out-of-the-money option could be affected to a large degree by short-term price moves. Decisions on whether to trade these markets will depend on your temperament.

This is only an observation, but it has been our experience that markets that make large moves to the upside tend to correct or move back lower more decisively and over a shorter period of time than markets that crash lower trying to recover. It may have something to do with the fact that small specs prefer to be long. However, it also brings to mind an observation made by Dr. Alexander Elder in his classic work, Trading for a Living. Elder compares slow and rapid market declines to a man falling down and his ability to get back up.

However, if a man falls out of a third-story window, it can take him considerably more time to recover. Elder contends that the markets behave in a similar manner. Thus bargain hunters that rush in to buy a commodity or stock after a rapid decline may be in for a disappointment, unless they are truly long-term investors. Markets fall that rapidly for a reason. Markets making new highs may not be the most desirable opportunities to sell call options. Again, we stress the advantage of knowing the fundamentals in addition to the technical indicators that you may be seeing on a chart.

A bearish technical trader who experiences a sudden rally in the market may see danger and be frightened out of his position. A bearish trader who knows the fundamentals and experiences a sudden rally in prices sees opportunity. However, if you are somewhat familiar with your fundamentals and have done some basic historical price studies or your broker has , you probably can tell the strikes that are more at risk and the CHAPTER 5 Strike Price and Time Selection 79 strikes that are downright ridiculous.

In this, we are talking about selling options against the existing fundamentals. Because you may deduce that the fundamentals are bullish or bearish to the market but not that bullish or bearish. In other words, the fundamentals are very bullish or bearish, but now those factors may be already priced into the market. When the media or the public picks up a story and runs with it, prices often get overblown. In this sole exception to trading with the fundamentals, options should be sold sparingly and only when the trader feels that the market has gotten entirely carried away.

However, these, unfortunately, are also the types of markets that give option selling a black eye. In the event that you are wrong, losses can accrue very quickly in your account. Therefore, it pays to exercise a few risk control measures that can help you to avoid a big drawdown. Allocate only a small portion of your portfolio to trades such as these.

While these are often the highest probability trades on the board, the consequences of being wrong can be more severe. If your regular position size is 10 option contracts, maybe only take three to five of these types of trades. This is the one instance where you may use technical indicators to look for signs of tops or bottoms. In a rapid move higher or lower, look for signs that the market momentum is slowing. But natural gas enjoyed a fundamental that played well in the press — a supply shortfall that looked good on paper and gave the public a reason why prices were rising.

Small specs rushed into the market and bought call options their favorite gambling method of choice to try to strike it rich. Unfortunately, by the time the media had caught on to the story, the market had long since priced in the lower supplies. While longterm fundamentals were shifting, the media sensation of shortages whipped fortune seekers into a frenzy. By the time peak usage season arrived in mid-summer, the market had already topped as higher prices began to substantially crimp consumption and distributors began to anticipate the slack autumn demand season.

Traders willing to sell options to this bullhappy crowd could have sold November In short, know your fundamentals. A good rule of thumb to follow is to fade the media and, more important, fade public opinion. In other words, do the opposite. If your fundamental analysis brings you to the conclusion that the market could continue to move higher, sell the puts and allow for sharp corrections when the specs get stopped out.

The more conservative investor can wait for the corrections and then sell puts. Remember the preceding example. If you thought that natural gas was overdone and faded the public by shorting the futures at The excerpt on page 67 was a weekly article written by James Cordier in May on this exact subject.

In reading it again, we felt it would cover this subject exceptionally well in its unaltered form. Checking open interest in a particular stock or commodity is another tool to use in your overall analysis of potential options to sell. The approach is just as effective now, if not more so, as it was in The alternative is to sell options with more than 90 days remaining.

Sell ahead of the curve. One reason, as we suggested earlier, is that the additional time value allows you the luxury of selling at strikes very far out of the money. In other words, he has to sell closer-to-the-money strikes to receive the same premiums that you received 30 to 60 days earlier. As the premiums begin to drop, your risk begins to drop as well. A good way to gauge where your options could be in 30, 60, or 90 days is to look at option prices for several months, side by side. This is a limited tool because it does not account for market movement.

Since the general public often favors buying options, one key indicator of where the public is positioned often can be determined by studying option open interest. If there is a discernible discrepancy between the number of open contracts in puts versus calls or vice versa, there is a good chance that the public is favoring one side of the market. A good rule of thumb—if given the choice—is to fade the public. For instance, if the open interest in puts in a particular commodity is 50 percent greater than the open interest in calls, and most of the traders holding long options are small speculators the general public , then there is a good indication that the public favors the short side of the market.

Funds and commercials would have sold the puts to the small traders. All other factors being equal, you may want to consider selling puts in this situation. The reverse would be true if open interest in calls was decidedly greater than puts. A perfect example of this phenomenon is taking place in the silver market at this time. Look at the open interest in silver options, puts versus calls. Open interest in silver puts as of yesterday stood at 8, Open interest in calls totaled 52, Call open interest is over six times put open interest.

And who might be selling these options to them? Probably professional traders and commercial silver players and maybe a handful of sophisticated individual investors. These are my own personal rules, opinions, and general observations. This is not to insinuate that the public always will be on the wrong side of the market, nor is it to suggest that this can be used as a trading system in and of itself. Nothing replaces solid fundamental and technical analysis.

This is one of many factors one can consider when selecting options to write. Option buyers, who often are the small speculators in the market, are trading the futures market hoping for big moves and big gains. This is why most small specs that trade are attracted to commodities—for the spectacular. If you are considering a certain strike and want to get a rough idea of what your option will be worth in 30 days barring more than a moderate price move , simply look at the same strike price that is set to expire one month sooner.

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For instance, in Figure 5. If you are comfortable with that level of deterioration, you could have the right month and strike. These differences in price can be more apparent in some agricultural commodities that are subject to planting F I G U R E 5. If the differences in months are too great, simply adjust your comparison to a strike that is approximately the same distance out of the money. This is often a matter of individual preference, but we may be able to offer some suggestions.

It has been our experience with SPAN margin that although margin requirements decrease as premiums decrease, return on capital invested tends to decrease as well as premium decreases. Again, this is not a rule set in stone; it is more of an observation from years of option selling. However, when considering different strike prices, it may be helpful to compare premiums of different options with their respective margin requirements. For starters, the commission paid to your broker will come out of this relatively small premium.

But is it lower risk? Third, look at what you risk in a worse-case scenario, this being that both options go deep in the money and you, for whatever reason, did not get out beforehand. The other end of the spectrum is a trader who sells options for high premiums at closer strikes. This trader runs the risk of selling too close and being stopped on a small move or, worse yet, have her option go in the money on a small move. A balance must be struck.

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This holds true whether you are selling one option or Delta is the amount by which the price of an option changes for every dollar move in the underlying contract. The delta will give you a good idea of how far the option price will move in relation to the underlying market. For instance, if you look at the delta of an option and it reads 17, this means that for every one point the futures market moves, the option price will move 0. This sounds simple, but one must remember that the delta is constantly changing and readjusting with every tick in the market.

Thus the closer the underlying comes to your strike price, the higher will be the delta. It is our recommendation that you seek options with low to very low deltas when you are selling. They will have the lowest chance of ever going in the money. Maybe so, but we recommend it anyway. With this type of winning percentage, you should be able to withstand the occasional oddball who exceeds your strike.

Option margin, delta, and size of position all come second to selecting the right market in which to sell. If you pick the right market, none of these things should matter in the end. However, all your picks will not be right, and these factors can matter in an adverse move. Many investors who allocate a portion of their portfolio to options on futures do so not only for the opportunity for more sizable returns but also so that they can have a fun, exciting, and active portion of their portfolio that they can get in and get their hands dirty, buying and selling and calling plays.

Sorry, but if you like action, the trading plan in this chapter may not be for you, except for the part about the sizable returns. Then they start to get it. Sell one to two sets of options with expirations of two to six months away. Thirty days later, another set expires, and then another. The wait paid off. Each month you continue to sell one to two sets of options—on average—depending on when opportunities are present in the market.

This is what we mean by staggering. It is positioning your portfolio to have approximately one or more sets of options expiring every month. This is not to imply that every set of options that you sell are going to expire worthless. But this is an ideal to which you may want to aspire with regard to structuring your option selling portfolio.

It seems to have immense popularity among many of the traders whom we have advised. Perhaps it is because of the regularity for which it strives. Regardless, from a psychological standpoint, it can be desirable to be able to look at your statement and see that you have options scheduled to expire at regular intervals in the future. This is true whether you are an income- or growth-oriented investor.

You have now learned how to go about selecting markets and strikes for selling options effectively. This page intentionally left blank 6 C H A P T E R Use and Abuse of Spreads While thus far we have only discussed selling options naked, a trader wishing to sell options like a professional may want to consider spreading as an alternative strategy.

There are some brokers and authors in the industry who are not going to like what they read in this chapter. Given the right market situation, almost any strategy will work some of the time. Our intention is to share with you the observations we have made in working with hundreds of futures option traders over many years. We are not judging these approaches. We are only reporting on our experiences after implementing many of these strategies on a broad scale across a wide selection of market situations.

As you can see, it is the perfect type of spread for a market in this situation. Market intellectuals love to learn these strategies and how they work. However, our experience has been that a market intellectual does not necessarily make a good trader. Many traders new to options believe that it is necessary to learn all these spread combinations before they can trade effectively. This is not the case. Again, our point is not that these complex option spread strategies do not have merit. Traders who use these approaches effectively generally are people who have made trading their life, who know exactly what they are doing, and generally have paid their dues through many years of losses in learning the proper situations in which to use these approaches effectively.

Our experience has been that the transaction costs alone make many of these approaches impractical for the average individual investor. If this is you, then good luck. We wrote this book for the people who just want to make money. Nevertheless, there are a few things you should know about spreading before tossing your line in the water. Many brokerages love option spreading and often will recommend the strategy to their clients—especially in the case where the options are net long, or at the very least, short but covered.

This reduces liability to the client but more importantly to the firm, itself. This is not necessarily a bad thing for you. It can work against you, however. With each position having an absolute maximum loss, traders sometimes encouraged by their brokers may position all their funds into limited risk spreads, leaving little or none as backup. Misled by the limited risk aspect of spreads, this type of positioning shows terrible money-management technique that has the potential to damage an account. Net long spreads can be especially popular among younger, untested brokers who do not have the know-how or the experience to trade futures contracts or especially sell options with a usable riskmanagement agenda for their clients.

Employers of these inexperienced brokers will either encourage or require these brokers to recommend either buying straight options or buying covered spread positions. This is one reason why it is important to know the broker with whom you are working and her experience in futures and option trading. Situations that often can be played effectively with a futures contract or a single call or put also can be played with an option spread.

They are pitched to the client as a way to limit risk and increase leverage, which very well may be true. In other words, instead of buying a single option a strategy with which it is hard enough to turn a profit , a broker may suggest a multiple-option spread in which one or more options are sold in order to pay for one or more options that are purchased. Each spread can contain three to six options or more. Thus, instead of paying one or two commissions, the client pays three to six commissions per spread.

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This is not to suggest that every broker in the business is a money-hungry con artist. Quite the contrary, most brokers are good people who do not take advantage of their clients. As in every business, though, the brokerage industry has its bad apples. This is also not to suggest that because a broker recommends a spread to you that he is trying to con you. In many cases an option spread can be a viable alternative and a legitimate strategy to employ in a particular situation.

Consider the following example. What does it cost to get in? What is my risk? That sounds pretty good. It sounds pretty safe. So how many do you want? Has the broker lied or broken any compliance rules? She properly disclosed risk. What is the likelihood of this type of move in the market? But the broker sold John what he wanted— limited risk. This brings us to an important point. It is said that fear and greed drive the market. Your emotions will undermine you, and you will lose. While nobody wants to lose money, there is a difference between not wanting to lose and being afraid to lose.

If you are trading scared or afraid to lose, you have already lost. This is why many of these traders are drawn to option buying or covered spreads. You have to manage your own risk on this trade. If it moves against you, you have to get out. The market is not going to do it for you. It is simply an extra step you have to take.

The term itself implies unwarranted fear. But do not fear it. If you walk into a pit of combat, do you want to walk in looking like Woody Allen, shivering and jumping at every twitch of the market? Or do you want to walk in like Russell Crowe in Gladiator? Both have no desire to get slaughtered. Both may take measures to protect themselves. This very concept of fear, or lack of it, is what makes one more likely to achieve victory while almost ensuring the other of an early slaughter. The markets work the same way.

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This is why we are going to strongly recommend, right now, that you highlight the words in the heading that follows. For success in trading, protecting your investment capital is of utmost importance. The market smells fear like a rabid pit bull. The investment classic, Market Wizards, by Jack Schwager, seems to put forth a recurring theme in trading or investing. They think of it as playing a game.

The money is a by-product of playing the game successfully. This enables them to remain unemotional, objective, and patient in their trading approach. The primary goal is still to make money. It is the way they approach it in their minds that gives them an edge. However, if you can give up that fear and the need for absolute limited risk and instead focus on managing your risk, you will have already placed yourself above most small-spec traders in the market.

The industry caters to the greed and fear of small speculators, which is why buying options and long option spreads is so popular with this group. We want to clarify this concept of securing absolute limited risk versus managing risk. A healthy respect for the market is essential. Our point is that if you fear the market so much that you must have absolute limited risk, the high price you pay for that luxury most likely will sabotage you in the long run. Securing absolute limited risk primarily refers to buying options.

Many traders especially new traders become enamored of the concept of limiting risk. They are somewhat familiar with the concept of risk in the futures market, but it is a somewhat vague and disturbing notion to them. Being able to participate in these alluring markets while absolutely limiting risk is very appealing. Buying calls or puts sounds awfully good to them. Futures traders who use stops do not have absolute limited risk. Markets can trade through stops. These traders are managing risk. If you understand the risks, understand the market and the underlying fundamentals driving it, understand what could move the market against you, and position yourself so that the market will have to make a long-term move before your losses become significant, it becomes much easier to manage your risk.

You can give yourself a remote chance of losing on a trade and still entail unlimited risk. The bookie took the bet for 10 cents. The gambling house, in essence, had unlimited risk on the bet. What if the gambling house could cut its losses as soon as somebody saw Elvis riding in on the long-lost racehorse? The gambling house had, for all practical purposes, unlimited risk on the bet. But it managed its risk exceptionally well.

The better, however, was able to limit his risk on the bet. His risk was limited to 10 cents. Which one do you want to be? We are not suggesting that the odds of selling options will be this much weighted in your favor. We are only illustrating the differences between limiting and managing risk. There are option buyers and spreaders out there who are willing to bet on Elvis for the chance at big gains and limited risk.

In keeping with this theme, we tend to advise against positioning in spreads that leave the trader net long options although these spreads can be more exciting for the action-seeking trader. The next several pages highlight some of the most popular net long option spread strategies along with some observations of which you may want to be aware. Moreover, it is a net long option spread which means it is for option buyers and therefore, we would not recommend it on those grounds alone.

They are pitched as a way to reduce the cost of buying an option, therefore enabling a trader to take more positions imagine that! Bull call spreads sound good on paper, but we have rarely seen them work in practical application. Unless the market moves to a certain point above the highest strike on the spread and remains there through expiration, both options generally will expire worthless, resulting in a loss for the spread holder. A bull call spread is illustrated in the following example: A bear put spread works the same way except on the other side of the market with puts when the trader is bearish on the market.

It sounds too good to be true! It does, and it makes a great sales pitch to novice traders. Of course, there are situations where this strategy could work well. It is certainly possible for the market to make this kind of move. But is it likely? This is where knowledge of the fundamentals becomes so important. The problem with this, especially in predicting big moves, is that the market is trading at its true value every single day of the week.

You have to see something coming in the future that the rest of the market does not. You have to predict almost exactly where the market will go. Then it has to make a substantial move in your favor in a very short period of time. In a bull call spread, the options often will have very similar deltas. In other words, the long option has to go in the money and remain there through expiration for the buyer of the bull call spread to reasonably profit. And we already know the percentages and therefore can predict the chances of that happening. This proved especially frustrating to me as a young broker when, as a team we put countless hours of research into a market, came up with a reasonable synopsis of the market that, surprisingly, often was correct, and then tried to position using an option spread of this nature.

At the time, we felt that we were protecting clients and giving them what they wanted—low investments and limited risk. What would happen is we would release a bullish bearish outlook for a market and then recommend a bull call bear put spread. The investor would place the trade, and the market indeed would move higher. The investor would call in. That market did just what you said! How much did we make? The market had moved higher, but neither strike had been attained. Thus, while the closer-to-the-money long option had appreciated in value, the losses from the more distant short option had almost offset all the gains.

Most of the time, in the following weeks, broker and client alike would watch disappointedly as the market then topped out or went into a sideways trading range as the bull call spread slowly, deteriorated, and died on the vine. Bull call or bear put spreads can work if the market goes exactly where you think it is going to go and stays there.

But it has to be there at or near expiration to really make it worth your while. In other words, you not only have to pick where the market is going, you also have to decide when it is going to be there. As we now know, crude oil prices declined sharply into the third quarter of Yet another reason to stay out of the bull call: As we will see in the upcoming chapter, doing the exact opposite of this strategy can be a solid way to build equity in an option selling account. Ratio spreads are popular with the some investors because they are a short option credit spread that actually offer additional upside if the trader is correct in his assessment of market movement.

However, the whole point of option selling is to stop trying to guess what the market is going to do. We only want to worry about what the market is not going to do. It can withstand a certain but not extreme amount of movement against it, giving it marginal staying power in the market. It offers the trader the possibility of a substantial payoff should the market move to the traders desired price point.

The structure of the trade can even exaggerate losses in the case of a substantial adverse move. It can be cumbersome to position at the desired premiums on both sides. Ratio spreads share the same basic drawbacks of selling naked, theoretically unlimited risk and potential for margin increases in adverse market conditions. However, the ratio involves selling several short options while buying only one protective option. This means that in an substantial adverse move, losses can begin to multiply quickly. A good broker can go far in alleviating drawbacks 2 and 3.

However, as mentioned above, reason 4 is what puts the spread on our nonrecommended list. Diagram of a Ratio Credit Spread A ratio call spread is generally considered a bullish strategy but can also be used by moderately bearish traders. A ratio put spread is generally considered a bearish strategy that can by used by moderate bulls see, its already complicated.

In a ratio credit call spread, a trader would buy an at-the-money or slightly out-of-the-money call while simultaneously selling two or three or more far-out-of-the-money calls on the same market. The sum of the premiums collected will be more than the premium paid out to purchase the near-to-the-money call. If the trader is entirely wrong and the market does a complete nosedive, all the options in the spread will expire worthless.

The following is an example of a ratio credit spread. In October of , Trader John is bullish on the soybean market. With January soybeans currently trading at However, since he feels that the market will still move higher, he decides to employ a ratio credit call spread. John executes the following trades: The ratio of the spread is 3 to 1; that is, he sold three options and bought one option.

Thus the term ratio credit spread. John would lose on this trade at expiration if January soybean options expire with the futures contract trading above A fair question that will be answered by ratio traders as follows: As the market moves higher, the three short In an optimal scenario, the This assumes, of course, that the options do not get exercised. Futures options rarely get exercised unless they expire in the money. At a futures price of Credit received when entering the spread plus the total dollar value difference between the two strike prices in the spread By dollar-value difference, we mean the monetary value, in dollars, of a move from the bottom strike to the top strike.

Since two of these calls are uncovered, John will accrue losses as though he were short two contracts of July soybeans from A ratio spread can be more conservative than selling naked in that balancing the long call versus the short call helps to smooth out short-term moves in the market and helps to avoid the larger drawdowns that can happen as a result of simply selling short. This however is only true as long as the market moves slowly.

In a rapid move, the value of the short calls begins to outpace the value of the single long call as volatility increases. As mentioned earlier, bears may also want to use a ratio credit call spread if they want to sell calls but protect themselves from short term spikes on prices. They sell the spread as a means of protection. However, as we will learn in the next chapter, it is our opinion that there are better, less complicated ways to protect ones short option position.

This involves constant delta measurements and adding addition contracts which is not recommended. The ratio credit call spread is a more aggressive trade for bulls in that it seeks the higher gains generally associated with option buying or futures trading. And that is inconsistent with our KISS approach: If bullish, sell puts. If bearish, sell calls. Option selling should be about simplicity and consistency. This spread, while exciting to consider in certain circumstances, offers neither of these attributes.

Investors who spend the time to learn how to use it must think they have discovered the Holy Grail of option trading—until they try to use it see Figure 6. This is one of them. You have certain advantages as an individual investor that you can use in your favor. A trader is neutral on April crude oil. In other words, the net debit on the trade is your maximum risk.

The trader has to pick almost exactly where the market is going and where it will be at a certain time in the future. Although these can qualify as credit spreads, for an individual investor, we would recommend staying away from all of them. It was selling 11 coffee calls, buying a futures contract, and then buying an at-the-money put for protection. After examining the trade, it actually made some sense. However, the market would have to move somewhat higher CHAPTER 6 Use and Abuse of Spreads although not too high for the investor to make money—after paying 13 commissions plus covering the cost of buying an at-the-money put.

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