When Selling Options Goes Bad – It goes Really Bad

Selling options in an effort to capture premium from theta decay and volatility declines is a popular options trading strategy among sophisticated investors.

When it works, capturing option premium can be a very valuable investment strategy.

However, when it selling options goes awry, things can get very ugly, very quickly. There’s an old adage in the investment world that compares selling options to picking up nickels in front of a steam roller. In many ways, this is quite accurate.

The risk/reward ratio for selling options is almost always unfavorable. Meaning, in exchange for the premium an option seller collects, they will have to take on an extraordinary amount of risk, especially if they sell the options uncovered, or “naked.”

Often times, this risk is not justified by the small amount of money received, premium, for selling the options.

For example, let’s say stock ABC is trading at $100 and a trader wants to sell the $105 strike price call option for $1.00 with 30 days until expiration.

If stock ABC is not above $106 at expiration (strike price plus premium received), the trader will collect the full value of the short call option. If this is the case, it’s great for the option seller. The trade will be fully profitable and the seller will keep the premium.

However, in reality, stocks do not always stay in small ranges, and history tells us this is definitely not always the case. There are unpredictable events that can occur at any time and annihilate short options positions, like tsunamis, earthquakes, natural disasters, etc.

Think about it this way: if every option expired worthless, everyone would quit their day jobs and sell as many options as they could get their hands on. This simple fact of the matter is that every option does not expire worthless, and many options actually expire with a lot more value than they started with.

Occasionally, the one stock that a trader sells options on will go absolutely parabolic, and when it does, it can fully take the trader out of the option selling game if their position is too large. Let’s say stock ABC went above $106 at expiration, or even any time before expiration.

If stock ABC was at $150 at the time of expiration, which is completely possible for stocks that receive bullish news (like buyouts, upbeat earnings releases, etc), just by selling one $105 strike price call option, the trader would be looking at a massive loss of $4,400 for one contract. Imagine if the trader sold 10 contracts; the loss would be $44,000!

Selling 10 $105 strike price contracts is very easy to do with leverage, especially portfolio margin. This is where traders need to be extra careful.

This reality of stocks sometimes moving dramatically underscores the necessity of keeping short options positons at a reasonable size to avoid account blowups due to black swan events.

Remember, the maximum profit that the trader could make in this example is $100 per contract minus commissions. And with most online broker’s commissions starting around $7 plus $0.75 per contract, the trader would only realistically be looking at a maximum profit of $84 in exchange for taking on theoretically unlimited risk.

This is why it’s paramount to keep your options trading commissions as low as possible. Options friendly brokers like Ally Invest and tastyworks have some of the lowest options pricing in the industry and are popular choices among options sellers.

Perhaps the best example of option selling not working out is the sad case of Victor Niederhoffer.

During the 1990s, Victor was one of the most successful hedge fund managers in the world. Of his many global investment strategies, one of his favorites was selling put options on stocks he though were fundamentally undervalued.

In 1997, Victor sold a significant amount of put options on Thai bank stocks after he presumed they had bottomed-out shortly after a massive selloff. Victor was wrong, and combined with a 7.2% single day decline in the Dow Jones Industrial Average, the Thai bank stocks that he sold a lot of put options on absolutely collapsed, and Victor was left owing his prime broker more money than his investment fund had. In other words, his trading account blew up, and it put him out of business.

Not only did he literally lose all of his investor’s money (hundreds of millions of dollars), but he also had to pay his prime broker additional money, as the liquidation of his short put options resulted in unavoidable losses greater than the value of his account.

This article is not intended to discourage traders from selling options. Rather it should merely serve as an ominous reminder that option selling can occasionally go bad, and as such, traders should never let their positions grow too large relative to their account size. Otherwise, they might find themselves in a Victor Niederhoffer-type position.

Related Posts

 

MarketTamer is not an investment advisor and is not registered with the U.S. Securities and Exchange Commission or the Financial Industry Regulatory Authority. Further, owners, employees, agents or representatives of MarketTamer are not acting as investment advisors and might not be registered with the U.S. Securities and Exchange Commission or the Financial Industry Regulatory.


This company makes no representations or warranties concerning the products, practices or procedures of any company or entity mentioned or recommended in this email, and makes no representations or warranties concerning said company or entity’s compliance with applicable laws and regulations, including, but not limited to, regulations promulgated by the SEC or the CFTC. The sender of this email may receive a portion of the proceeds from the sale of any products or services offered by a company or entity mentioned or recommended in this email. The recipient of this email assumes responsibility for conducting its own due diligence on the aforementioned company or entity and assumes full responsibility, and releases the sender from liability, for any purchase or order made from any company or entity mentioned or recommended in this email.


The content on any of MarketTamer websites, products or communication is for educational purposes only. Nothing in its products, services, or communications shall be construed as a solicitation and/or recommendation to buy or sell a security. Trading stocks, options and other securities involves risk. The risk of loss in trading securities can be substantial. The risk involved with trading stocks, options and other securities is not suitable for all investors. Prior to buying or selling an option, an investor must evaluate his/her own personal financial situation and consider all relevant risk factors. See: Characteristics and Risks of Standardized Options. The www.MarketTamer.com educational training program and software services are provided to improve financial understanding.


The information presented in this site is not intended to be used as the sole basis of any investment decisions, nor should it be construed as advice designed to meet the investment needs of any particular investor. Nothing in our research constitutes legal, accounting or tax advice or individually tailored investment advice. Our research is prepared for general circulation and has been prepared without regard to the individual financial circumstances and objectives of persons who receive or obtain access to it. Our research is based on sources that we believe to be reliable. However, we do not make any representation or warranty, expressed or implied, as to the accuracy of our research, the completeness, or correctness or make any guarantee or other promise as to any results that may be obtained from using our research. To the maximum extent permitted by law, neither we, any of our affiliates, nor any other person, shall have any liability whatsoever to any person for any loss or expense, whether direct, indirect, consequential, incidental or otherwise, arising from or relating in any way to any use of or reliance on our research or the information contained therein. Some discussions contain forward looking statements which are based on current expectations and differences can be expected. All of our research, including the estimates, opinions and information contained therein, reflects our judgment as of the publication or other dissemination date of the research and is subject to change without notice. Further, we expressly disclaim any responsibility to update such research. Investing involves substantial risk. Past performance is not a guarantee of future results, and a loss of original capital may occur. No one receiving or accessing our research should make any investment decision without first consulting his or her own personal financial advisor and conducting his or her own research and due diligence, including carefully reviewing any applicable prospectuses, press releases, reports and other public filings of the issuer of any securities being considered. None of the information presented should be construed as an offer to sell or buy any particular security. As always, use your best judgment when investing.