Tip 1: Have a Disciplined Plan
Writing options should not be treated any different than any other type of investment. You must plan your trade and trade your plan. That being said, you must determine the profit and risk parameters around each trade. In the case of writing options, your maximum profit is the premium collected upfront. The struggle many option writers face is how to manage the position when the market begins moving against them.
Writing naked options are one of the most difficult strategies to manage because the risk is unlimited. Leveraged markets, like the futures markets, can move very quickly, which can make it extremely difficult to properly manage risk. Even if you have a mental stop to cut your losses, a severe move in the market might not allow you to exit at that point. Premiums can double or triple before you have a chance to buy back the option. This is why it is so important to have a concrete plan in place. In the event a market does move against you, your trading plan will allow you to act quickly to prevent further damage.
If the concept of unlimited risk is unappealing, one solution to naked options would be credit spreads. Credit spreads have predetermined trade parameters on both the profit and loss side of the trade. You can easily determine your best and worst case scenario upfront. The majority of options will expire worthless, but that doesn’t mean the position won’t go through its ups and downs. By accepting the risk/reward parameters of the spread, you should be comfortable sitting through the day to day fluctuations and only make modifications if your long term outlook changes.
Tip 2: Control Your Leverage
Options provide a fantastic opportunity with leverage; however it is important to be smart in how to use this leverage. A unique obstacle option writers must overcome is margin. Unlike the underlying futures, margin designated to selling options is not a flat rate. Instead, margin is determined by SPAN. SPAN is a set of sophisticated algorithms that determine margin according to your positions one day risk. The distance a strike price is to the underlying, the time left until expiration, and volatility are all factors that can affect our margin. That being said, margin is simply a guideline. This is why leverage is so important. You might be properly leveraged according to your margin on day one, but as time goes by and as the underlying futures moves, the margin can drastically change. Dramatic, volatile moves can cause traders to exit positions early due to margin calls. The greater the leverage, the more sensitive your position is going to be to these price swings. This is another reason why many traders prefer credit spreads. Credits have a defined risk and will in turn have less severe margin swings.
Tip 3: Do Not Hang on to Worthless Options
The point of writing options is to collect the time premium and allow the value of the option to decay. Although the goal is to have our options expire worthless, it does not mean we cannot buy the option back early. This is especially true when there is a lot of time left on the option. If 80-90% of the total options value has decayed, it does not make sense to keep on the risk of the position for the extra 10-20%. There are certain strategies that will require holding the options until expiration, but unless your strategy involves writing far out of the money options for a few ticks, it would likely make sense to take the risk off the table. It is important to continually reevaluate the risk and the management of the trade throughout the life of the position.
Tip 4: Be Aware of Major Reports and Events
Whether you are a technical trader or a fundamental trader, you must be aware of key market reports and events. You should have access to an economic calendar that will identify all scheduled reports. We will need to keep these dates in the back of our minds when analyzing our trades. As discussed in our last tip, if the majority of our option’s premium has been removed prior to a report, it might be best to take the risk off the table in case the report is extremely one sided.
Tip 5: Choose Markets You are Comfortable With
We should have a good understanding of the markets current trend and the long term fundamental picture. An awareness of the fundamentals, scheduled reports, and key technical areas (trend lines, moving averages, pivots, etc.) are vital aspects of how we analyze our trade. The more comfortable we are with what is driving the market, the more confident we can be with our analysis. The more we trust our analysis, the easier it will to evaluate our position and determine if a sudden move is a short burst in the market or the beginning of a new trend. We should have a good feel for the market’s volatility and typical trading range, so we can identify when the current market environment begins to change. This comfort and knowledge should help you stay more disciplined and follow the trading plan established upon entering the trade.
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Spreads Risk Disclosure: A spread is defined as the sale of one or more futures or option contracts and the purchase of one or more offsetting futures or option contracts. It should be recognized, though, that the loss from a spread can be as great as – or even greater than – that which might be incurred in having an outright futures or options position. An adverse widening or narrowing of the spread during a particular time period may exceed the change in the overall level of futures or option prices, and it is possible to experience losses on both of the futures or options contracts involved (that is, on both legs of the spread). In addition, spread trading increases transaction costs because the customers will be charged commissions on each leg of the spread.
Options Risk Disclosure: An option on a commodity futures contract is a right, purchased for a certain price, to either buy or sell a commodity futures contract during a certain period of time for a fixed price. Although successful commodity options trading requires many of the same skills as does successful commodity futures trading, the risks involved are somewhat different. For example, if a customer buys an option (either to sell or purchase a futures contract or commodity), the customer will pay a “premium” representing the market value of the option. Unless the price of the futures contract underlying the options changes and it becomes profitable to exercise or offset the option before it expires, the customer’s account may lose the entire amount of such premium (together with the costs of commissions and fees incurred to purchase such options). Conversely, if a customer sells an option (either to sell or purchase a futures contract or commodity), the customer will be credited with the premium but will have to deposit margin due to its contingent liability to take or deliver the futures contract underlying the option in the event the option is exercised. The writer of the option is however at unlimited risk with respect to the call option written, and risk on the put option of the amount should the price of the futures contract drop to zero. Sellers of options are subject to the loss which occurs in the underlying futures position (less any premium received). The ability to trade in or exercise options may be restricted in the event that such trading on U.S. commodity exchanges is restricted by both the CFTC and such exchanges, and it has been at certain times in the past.