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.
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