Some Common Pitfalls in Options-Selling

 | Nov 13, 2012 | 12:00 PM EST
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One of the more interesting discussions around Chez Melvin this past weekend has now spilled over into the week. The topic of options-selling came up, as a couple of folks have recently had their heads kicked in and their net worth diminished by disastrous short put positions. I have been known to sell puts from time to time, and have found the conversation to be one of great interest. The traders with losing options positions were experienced investors, but new to the options-selling game. They made the same mistakes I always see made by professionals and neophytes alike.

Selling puts on stocks, indices and ETFs can look like free money. We all know most out-of-the-money options expire worthless, with the seller keeping the premium. What most traders fail to take into account, however, is that options payoffs are asymmetrical in nature. You can sell premiums and have 90% winners, and end up broken by that final trade. Options-sellers can find themselves collecting pennies and paying out dollars.

I only sell options on stocks I want to own. Valuation of the underlying stock is the first and foremost concern. If it is not cheap, I don't care where the options prices are. I have no interest in the trade. This is where most people lose money as options-sellers. The premiums on the darling and popular stocks are often fat, and just too tempting to pass up for many traders and investors. Why sell options for a 2% or 3% monthly return when you can collect much more than that by selling premium on stock like Apple (AAPL) or Chipotle (CMG)? After all, they just keep going up and everyone loves them. What could go wrong?

Well, the stock could fall out of favor, as we have seen this year with these two glamour names. If you sell puts on one of these names and collect the fat premiums, and the stock falls out of bed, you are going to lose a lot of money. You could end up being "put" the stock and forced to buy shares you do not really want to own for the long term. If you've compounded the error by posting minimum margins, you'll be facing a margin call of epic proportions. I always post the full purchase price of the underlying stock at the strike price.

The other mistake often I see will seem counterintuitive: I really do not like to sell options on a rising tape. It would seem that, when selling puts as the prices rise, the price goes higher and you collect the premium. The problem with this theory, however, is that each time you roll over the position you will be selling at higher strike prices. In a rising tape, volatility is usually rising as the price weakens. Markets are not unidirectional, and if you have lost track of valuation first and sold at ever-higher prices, a small correction can wipe out a years' worth of gains.

I like to sell puts on stocks no likes at prices that I believe are too cheap not to own -- so I hope the stock gets "put" to me and forces me to buy at a price that's lower than current levels. I prefer to sell them when the market is declining and there is a touch of fear in the air, as this leads to fatter options pricing and better back-in entry points for my long-term position or higher premiums in my pocket. As a rule, I pretty much never want to sell options of any kind when the CBOE Volatility Index (VIX) is below 20. I have seen way too many people carried out of the arena on their shield because of a volatility spike. I would rather be the guy selling insurance when everyone is willing to pay too much to protect against a downside move that has already started.

Over the years I have found that my best experiences in selling options have been in stocks that are so unloved that there is not much options-related activity. These usually have wide spreads and lower open interest. In these cases, I will post an offer between the spread, based on my calculation of option value, and my order gets filled more often than not. It may take a few days, but I am able to sell an option on a stock I like at a price I like. I scale into stocks, so I do not need to sell 50 or 100 contracts at a clip. Just as with stocks, my best results in the options-selling business have come from doing what no else is doing and trading where larger competitors simply cannot.

Options selling can be a profitable tool for value investors. As with all tools, there is a time to use it and a time to leave it in the box. Using the tool in manner for which it was not intended can lead to serious injury or even financial death. Don't be that guy.

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