If you are going to enter into the world of selling options you have to know your options (pun intended) and the risks that come with each. I love to sell options because I like receiving premiums rather than paying premiums, much like an insurance company. Option selling strategies can vary greatly.
I’ve done very well with selling time value, mainly with naked put options and sometimes selling call options too. One of the tricks is to know when to sell which stock options – calls or puts. The reason some investors don’t like to sell premiums using put options is the increased risk associated with leverage during a bear market or even just a small, quick correction. The same risk can be present with call options, but to the upside in a bull market. The easiest way to protect against that concern is to not sell options on more than you can afford to buy. I typically try to follow that mantra, but have veered off course some during this month’s collapse.
The best way I can illustrate how to balance the overshoot is to walk through the trades I have going on Alcoa (AA) right now. All of the options I’m describing below expire in February.
I started off with a normal trade for me and sold four naked puts at the 30 strike on 1/10/08 while AA was trading at 31.59. I received $387.00 after commissions.
Soon after AA started to fall and fell fast. I decided to cut my losses on 1/22/08 and sold naked calls at 27.50, in the money to protect me if AA continued downward. This cut my losses by $866.99 if AA stayed below 30 where it seemed destined to lag.
The day I sold those calls the market rallied. I was in a pinch, but knew my options. Anything between about 27 and 30.50 would be break even and I could get out of a bad trade free and clear. I even had a small range in there that I could end up with a profit now. The rally was clearly a dead cat bounce and I sat back, sad that I had sold the calls a few hours too soon, but happy my worries were over. There were too many negatives to let AA get away from me.
That’s when AA extended it’s upswing. I knew it would be short lived and waited. On Friday, the day after I thought the rally (aka dead cat bounce) would end, AA started up again and was now over $31.00. I gave in and sold four new Feb 32.50 naked puts (AANZ) in the money and received $747.00 after commissions. That raised my ceiling to 32.50 where I could break even. AA rose throughout the morning and I was psyched to have played this one relatively safely. If it got above 33.00 I’d consider selling more puts.
Of course, as this market will do, everything flipped and AA finished the day down. Again I was a few hours ahead of what I should have done. I’ve traded myself in a circle with AA.
How the math is working out for me:
Now I’ve taken in $2,000.00 in premiums on a potential four shares to be shorted to the top side at 27.50. If I divide $2000 by 400 shares I have a $5 cushion per share. That means any close at expiration up to $32.50 is not a loss.
To the downside gets tricky because I have two strikes I’ve sold puts on. Using that same $5 cushion, I can look at my position in different ways to figure my next move. The highest naked put strike is $32.50. I can take the $5 from that and be safe all the way down to $27.50, if it wasn’t for my second highest naked put strike at $30. Once AA goes below $30 I’m obligated to buy 800 shares. So it gets trickier, but not insane. I don’t actually have $5 per share as a cushion once AA goes below $30.
I’m taking a loss on something in any direction, but I’ll have a profit in any direction on something else. Thinking of the $2,000 in premiums I have to play with, I can lose $1,000 down to $30.00 from the first strike on 400 shares. But under $30, I can only go $1.25 farther since it’s 800 shares. That takes me to a downside breakeven point of $28.75. The details are like this in a formula: $2000 = (400*2.50)- (800*1.25). By selling that last naked put I raised my profit/loss channel and shrunk it at the same time. What’s crazy is that I have three weeks to go before I’m out of this positon. If AA doesn’t close between 28.75-32.50, I’d prefer a slightly lower close over a higer close since I’d consider buying 400 shares of AA. It would have to be below 27.50 for me to be forced into all 800 shares and if it heads back down there, I’ll be selling more calls to lower my low side protection.
Enough about AA – I’ve done the same thing to an extent with NVDA too, but will cover the math of it another day. On Friday I got in deeper with NVDA as it rallied too. Of course it came back down like I thought it was going to the day before. While NVDA was on the way up, I sold four new NVDA Feb 25 naked puts (UVANE) and received $587.00 after commissions. My profit/loss picture is much worse on NVDA as I waited too long to sell calls on it and have sandwiched myself into a lose-lose situation. I could squeak out a profit if NVDA closes in the upper 24 range on February 15th and I buy back my last naked puts for a profit and take the stock assignment all the way back up to $32.50. I decided to sell those last Feb 25 naked puts because I don’t think NVDA will stay stuck in the mud for too many months.
So the question can be – Why would I be proud of breaking even or even taking a reduced loss? The answer is simple. Most of my trades are profitable. I’ll never be close to 100% right, so the bad trades need to be managed with capital preservation in mind. That’s what I’m dealing with in January, capital preservation, so I can live to trade another day when selling naked puts is easier.
Wow, that’s pretty complicated and time consuming. Be sure plan for the worst since that’s what usually happens when the underlying gets volatile and unpredictable. I’m thinking about using break-even stops when my picks are wrong. I’d rather get out cheap and quick than getting stuck in a big long loss. Good luck!
This is a great way to make money in volatile markets but it is so important to be disciplined on how you protect your risks. Theoretically, you could end up selling more and more contracts on different swings and be in trouble if the stock actually breaks out of its range and develops a strong directional move. That is where being a professional and understanding how each piece of the complex trade behave helps you. You must be able to react quickly and decisively to offset your risk.
I appreciate you sharing the details of this trade. I’m sure its very helpful for someone interested in options to see the different scenarios that can ensue.
Good luck with AA,
ZDS
Thanks Zach – I’ll continue to update my progress with this one. You are exactly right, I cannot overstate the importance of understanding the damage a breakout of my predicted range can do if I let it get too far.
Mule – good point, nothing wrong with cutting losses early. Had I not been sleeping at the wheel I should have done that a few weeks ago.
Alex, I am curious why you would change your mind so quickly? If you originally thought a stock was good and went positive delta, why not just double up on the delta on the way down (i.e. Why not just sell more puts at lower strikes?) I guess maybe I am too much fundamental and not enough technical…
The short answer is that I needed to preserve capital. I think AA will be fine, eventually. What I don’t know is when. Once support broke and the markets were overall very bearish, I didn’t want to fight the masses. This was the right option in my mind to stop the bleeding in the short term. If we actually go into a recession, AA could suffer longer.
That makes a lot of sense. I was confusing a stock specific strategy with a generic strategy. I agree that AA (and other commodity companies) are going to suffer if we see a deceleration in demand.