Short option trading often gets a very bad rap. The critics always come out and say that you are trading a limited reward unlimited risk strategy and that sooner or later you're going to lose and give back all your gains, or worse blowout your portfolio. These critics are not completely wrong because traders continue to make the same mistakes that end up proving them right. If you want to be a successful trader in the long term you have to stock making these mistakes.
Is your only adjustment strategy to roll your options? Do you know the difference between calls and puts and what makes shorting them so different? Do you like to short options during earnings? Do you always hold your options till expiration and without insurance? If you answered yes to any of these questions your portfolio could be at risk.
Mistake 1: Your Adjustments Only Include Rolling Positions
Most traders using short options don't have a good exit strategy. With options it is imperative to have an exit plan laid out before you take a trade. Options give you the ability to not only simply exit your trade when it isn't work but to adjust it. Adjusting a position involves adding or subtracting options or stock to try and salvage a position. You adjust to lessen the pain of the failing position with the hopes of being able to hold on longer so it may turn around in your favor. With options there isn't a typical one size fits all play you can use to adjust your position.
One method of adjusting involves rolling a position. Rolling positions involves closing out your current position and taking another position either farther out of the money or further out in time. There are several types of ways a position can be rolled. You can do a horizontal roll which means you are going to keep your strikes the same but roll your position to a different month.
This is getting confusing, we need an example:
We have a short put on The Option Prophet (sym:TOP), more specifically, we sold the March 65 Puts when TOP was trading at $75. TOP is not doing what we thought (we wanted it to go up) and is now trading at $66. This is putting a lot of pressure on our short position and it is definitely taking losses. We still think TOP is going to climb in price but we are going to need more time to make that happen so we want to do a horizontal roll and push it out to April. To make this happen we take the loss in our March position and open a new position in the April 65 Puts. Even though our strike price is the same (65 in this case) we have bought ourselves more time for our position to work.
If there is a horizontal roll there is definitely a vertical roll. Vertical rolls keep the same expiration month but change strike prices.
Lets use our example from above. We have on our short March 65 Puts on TOP and it is moving against us. We still have a lot of time before March expiration but we need to by ourselves some more room. We opt to go with a vertical roll and close out our March 65 Puts and open March 60 Puts. This roll doesn't buy us more time but it does give us more room.
Last but not least is the diagonal roll. Diagonal rolls combine the horizontal and the vertical roll. Still using our example from above we would roll our March 65 Puts to April 60 Puts. This roll gives us both more time and space for our position to work.
Now that we know what rolling options is exactly let's discuss why they are not good and why you should avoid it.
When making adjustments to your position your goal should be to reduce certain risk. Usually that means you are trying to cut down your delta. What you don't want to do is add more risk to your position. When you roll a position that is exactly what happens.
Lets go back to our previous example but add in more numbers.
Our original short position is short TOP March 65 Puts at 2.00. When TOP begins to move towards 66 our position is going to start taking unrealized losses. We want to do a diagonal roll (move it down and out) to buy us some more time. We need to close our March position but it is now worth 10.00 which means we are losing 8.00 per contract. The contract we want to roll down to is April 60 Puts which are currently trading for 4.00. To at least breakeven we need to take twice the amount of contracts as we did in our March position. Let's run the math for 10 contracts of our March 65 Puts.
Original short gave us a $2,000 gain (2.00 x 100 x 10)
We had to take a loss when we closed the position of $10,000 (10.00 x 100 x 10)
That gave us a net loss of $8,000 (10,000 - 2,000)
When we opened our new position we had a gain of $8,000 (4.00 x 100 x 20)
Now if our position works out we are simply going to break even on this trade. That's great because we turned a potential loss into a breakeven trade. The problem is we did it by doubling down on our position and our overall risk. What happens if the position doesn't turn around in our favor, but instead continues to fall? Now our loss would be double. Would you be able to roll again and double down again?
If TOP dropped to 60 our short April 60 Puts would now be worth 12.00. This would give us a position loss of $24,000. Rolling down your positions is a great way to blow out your account because you keep adding more risk until you can't afford to anymore.
Don't use rolling options as your one size fits all adjustment strategy. Come into your short strategy with alternative adjustments.
Mistake 2: You Treat Short Calls and Short Puts The Same
All short options are not created equally. Thanks to option skew this is especially true when it comes to calls versus puts. We know that the majority of market participants hold long stock, usually over the long-term. Think of how many positions and the size of those positions mutual funds hold or retirement accounts such as 401-ks. A mutual fund, retirement accounts or other large portfolios can't simply enter and exit positions on a whim so they need a way to protect themselves against a market downturn.
These investors go into the market and purchase portfolio insurance. Insurance, in stock market terms, comes in the form of long put options that are deep out of the money. If the market begins to crash these cheap out of the money puts are suddenly worth a lot of money.
What happens when people purchase options? It drives up the price and volatility of those strikes. We compound this even further by noting that when it comes to short options, or writing options, the majority is done through calls in the form of covered calls. Covered calls are widely used because they are a good beginner strategy, the pair well with a long stock portfolio and they can be traded in retirement accounts. What happens when people sell options? It drives the price and volatility lower in those strikes.
Why does this matter to option sellers? It matters because a lot of traders will sell calls like they are selling puts. With puts, due to skew, you can go further out-of-the-money and still receive a sizeable premium. To get that same premium in calls you have to bring your options closer to being at-the-money.
The advantage to shorting put options is that you get a decrease in volatility as the market begins to climb. This works double well for your positions. Most traders short calls after the underlying has made a large run higher and they think it has gone too far and needs to drop. The problem is that now that the underlying has ran higher its implied volatility has dropped off and maybe even fallen to a low. If you enter a short call now, the underlying moves higher but volatility doesn't move lower because it is already at the lows. This works double against your position.
Typically the best time to short call options is when volatility is coming off the highs and beginning to fall. Don't forget that an underlying that has run up can continue to run even though it seems improbable.
Mistake 3: You Are Shorting Options Over Earnings
Corporate earning announcements are a mess. The way the market reacts to earnings can be a complete crapshoot. A corporation could report good numbers or bad but it depends on how it compares to what analyst believe the company will do. This is because the market has already factored in what analyst are predicting so if the numbers are off from that the market needs to readjust their thought process.
This readjustment happens in a very short time period, usually before the market opens again. If the numbers are way off from analyst it can send the underlying price extremely high or low while this new information is processed.
Most traders are taught a few things when it comes to options and earnings. They are taught that implied volatility rises incredibly high before the announcement and that implied volatility drops dramatically right after the announcement. Naturally this would lead option traders to pick an option strategy that involves being net short, such as a short straddle, short strangle or iron condor.
These strategies offer traders an limited reward for usually an unlimited loss or a large loss. Normally that is not an issue when you have the ability to manage and adjust your positions as the trade progresses. With earnings you are not afforded that time. Earnings are announced when the market is closed, the underlying moves after hours (when options don't), and the market opens with the move already completed.
Shorting options over earnings is another good way to blowout your portfolio. A lot of earnings announcements will fall in line and your trades will be profitable. However, there are still earning surprises that will completely blowout one side of your trade or the other giving you a max loss. This one loss can waste away all those little gains you've picked up before plus some. You would be surprised how many times an earnings surprise can jump past your iron condor strikes that are 20% out-of-the-money. When trading earnings, it is more profitable to go long.
Mistake 4: You Hold Your Options Even When They Are Not Worth Anything
One of the joys of shorting options is that you can open the position, hold it to expiration and then watch it disappear never having to pay a commission to close it out. While that is a nice perk, here is a reason that you should be careful always holding positions till expiration.
When people look at option pricing models, like Black-Scholes, use option analyzing tooks, or option calculators they don't realize that these models and tools don't work for deep out-of-the-money options. These tools work best when it comes to near term at-the-money options but fail when it comes to further out deep out-of-the-money options.
One way you can typically notice this action is by look at the Theta of an out-of-the-money option. Right now I can look at an option that is not even 5% out-of-the-money with two days left till expiration and it has a price of .08 and a theta of .13. That means it plans to lose 13 cents each day for the next two days, except the option is only worth 8 cents.
When options are deep out-of-the-money they become insurance for bigger players in this market. As insurance these options will hold some type of value all the way through till expiration. If you've ever shorted a cheap option and realized the price doesn't typically go anywhere until you get right on expiration you know what we are talking about.
The reason you don't want to sell these cheap options or hold them till expiration is because they can turn around on you and do it quickly. Options used as insurance can shoot up on price on the first sign of trouble in the market. If an option is worth 5 cents or 25 cents you are holding your portfolio hostage over $5 or $25. It is best to close these options out and move on.
There is a reason most brokerages allow you to close options worth 5 cents or less for free. Brokerages need to look out for themselves so they can remain in business. It is better for them to have you take off that risk than keep it open and have it blowout your portfolio and theirs.
Mistake 5: You Enter Short Positions Without Insurance
If you run a predominantly short portfolio you will have a lot of positions that are defined risk and have some that are undefined risk. Even the defined risk trades will have a risk that is greater than your reward. You are okay with this because you sacrificed your risk/reward to gain in higher probability trades.
That does not mean, however, that you are willing to let one losing trade cancel out all of your smaller gains. Protect your portfolio and your gains by taking on some insurance. Insurance can be placed on your overall portfolio by buying some 'units' in the indexes or they can be placed on individual trades by buying the 'units' in those names.
When looking for units you want to start at options with deltas between 2 and 5. This means for an average priced stock the option will be worth $0.25. These are the options that are built for insurance. They will sit around at approximately the same value until it comes time to explode in price. If your stock or the market doesn't drop they will simply fade away from your portfolio.
Insurance will cost you a tiny fraction of your overall credit but will save you a huge headache and a lot of money if they pay off. If you are trading individual securities you know that overnight news can drop a stock in an instant. A company suspected of fraud, a CEO that dies, an earnings leak, etc... can all drive the stock instantly and it can be difficult to account for.
Having a short option portfolio is a great way to trade in this market. Short option portfolios can be run just as successfully as a long option portfolio or even a hybrid system. The trick with this type of portfolio is that it places a large percentage of success on how well you can manage it. Traders will often find a lot of success targeting high probability trades only to lose it with a couple of mistakes that can be avoided. Don't get caught making these mistakes and now that you know about them you can work on reducing them so you may stay profitable for the long term.