Option Selling with Defined Risk

A Note for the Serious Investor:
The material that follows is written for high-net-worth and accredited investors who are serious about understanding the use of commodity options in a professionally managed portfolio. Futures and options involve substantial risk of loss, are not suitable for all investors, and only risk capital should be used. This article is for educational purposes only and is not a recommendation to buy, sell, or hold any specific futures contract, option, spread, or commodity position.

The “Fear Factor”: A Broker’s Perspective on Risk

Hypothetical Situation: The futures trader has just read yet another article about how selling options may enhance the returns in a portfolio. Curious, and somewhat excited, he picks up the phone and calls his broker. “I want to sell options. How would we go about that?”

“Sell Options!?” the broker gasps in disbelief. “Why would you want to do that? Don’t you know that selling options is risky!?” He then puts the investor on hold and calls the floor. “Buy 10 Crude Oil futures at the market!” he barks and then picks up the investor again. “Like I was saying, that’s probably more risk than you want to take.” He never blinks an eye.

This is the rap that option selling has historically received in much of the futures trading community. Many traders and brokers will be more than willing to trade the underlying stock or futures contract, yet shy away from selling options because of the potential for unlimited risk with naked options.

In reality, selling options can, in some circumstances, involve risk that is comparable to trading the actual underlying product, depending on the strategy employed and how risk is managed. Options trading has continued to grow to new records year after year but I believe it has only been in the last few years that selling option premium has begun to catch on with individual investors. Unfortunately, confusion surrounding the risks in option selling has kept many investors from exploring how the strategy works.

Moving Toward a Structured Risk Model

To be sure, option selling does involve risk. What you may not know is that there are strategies in which an investor can sell options with defined risk while still seeking to benefit from time decay.

Professionals know that capital preservation is a critical part of any trading plan and generally build the rest of the model around it. Less experienced traders may at times become more focused on success percentages or profit potential than on the importance of risk management.

One way to approach option selling in a more structured, risk-conscious manner is through the use of vertical spreads.

Naked vs. Spread: What “Covered” Really Means

Many people think of a covered position as selling an option and then owning the underlying contract, especially regarding stocks. However, holding the underlying is only one way to cover an option and not necessarily one we would recommend when trading futures options.

Covered, for our purposes here, means you have mitigated the unlimited risk of selling a naked option by buying or selling another option or options that partially offset or covers it. Covered option selling can offer many of the same benefits as selling naked options, but without the unlimited risk that makes many investors uneasy.

Real-World Case Study: The Bull Put Spread

The following covered strategy is one we view as offering meaningful risk-management benefits, along with potentially favorable SPAN margin treatment.

The Risk Calculation:

The maximum loss on this trade would be $3,150 not including transaction costs. That is, the dollar difference between the two strikes (10 cents x $375 per cent = $3,750), minus the credit collected ($600). This maximum loss would only be realized if March Coffee futures were below 1.50 at expiration. The profits from the purchase of the 1.50 put would offset losses below that level.

*Transaction costs of approximately $72 not included. Net premium collected ~ $528

While this structure does provide defined risk, one would not necessarily have to hold this spread to its maximum loss capacity. The spread can be bought back at any time prior to expiration during normal market conditions.

Drawbacks and Conclusion

Of course, there are drawbacks. Credit spreads must generally be held close to expiration before full profit is realized. In addition, spreads must often be sold slightly closer to the money than a naked option in order to collect a similar premium.

However, we believe, a vertical credit spread is a smarter way to pursue option premium while knowing the maximum risk from the start.

So much so, we created a portfolio inside of The Ultimate Evolution of Option Selling Program that exclusively trades defined risk spreads.

Common Questions (FAQ)

Can the maximum loss be exceeded?

No. The long option acts as a hard floor, capping the loss at the difference between strikes minus the credit.

Is this better than selling “naked” puts?

It is different. Naked puts offer more premium but carry “black swan” risk. Spreads are for traders who prioritize capital preservation.

How does this affect my margin?

Because the risk is capped, exchanges typically require less margin to hold the position compared to an uncovered short option.