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The Reality Of Selling Options Short

|Includes: Invesco QQQ ETF (QQQ)

In a search engine I run into http://www.options-trading-system.com/ options signals service. From the first view the service looks amazing. However, how to separate the reality from the marketing tricks? How to see the real picture?

First we have to take a look at the uncovered options in general.

Options trading is very risky. When you pick up any tutorial on options trading you will see the statement that selling options short is extremely risky where size of losses is unlimited.

Unlimited losses - True or False

Unlimited losses sounds scary. However, this is a theoretical statement which is not correct in real-trading. The reality is that if "trader John" has $10K in his trading account he may loose only $10K and not a penny more. If John uses his house as a collateral to borrow additional $1M and he puts this money to his brokerage account then he may lose $1M which would include losing the house. Until then, his loss is limited to $10K. No matter what he trades, either he buys options or sell options or trades futures, he may not lose more than $10K.

Brokers will not risk their money to let you gamble on the market. They can lend you, yet, as soon as they see any risk they will liquidate your investment to get their money back. The mechanism of margin rules is set to bring the brokers' risk of losing money to zero and to limit a trader's loss to what he has on his account or what was allocated to a trading.

"Unlimited losses" is a correct statement, however, this is a theoretical statement. The reality is that, your loss is limited to what you allocated - As soon as you about to lose everything, you will receive a margin call from your broker and if you will not inject (allocate) more funds, your positions will be liquidated.

This is the first important point that anyone involved in selling options short has to understand - no matter whether you buy options or sell options short, the maximum loss is 100% of allocated funds. "Trader John" may use $10K to buy options and he may lose everything when options expire worthless. Also, he may use $10K to sell options and his maximum loss is still limited to $10K only. You cannot lose what you do not have.

The Odds of Success

One of the reason why the options attract many traders is the potential to achieve a great profit in a short period of time by starting from a small investment. This is a dream of maybe every novice trader who comes to the market: "I will start with $10K and I buy options and in a year I will have $1M". It is very dangerous thought which should be associated with a thoughts of a casino gambler.

Theoretically, the same as in casino, an option buyer may turn $10K into $1M even in a month. The reality is that the odds of it happening are from zero to almost zero.

When it comes to options sellers, their gain is limited to 100% of the premium received for options short.

One of the rules of investment states: "Higher potential profit comes with higher risk". This statement does not go along with options trading tutorials where you will see that options buyer has potential unlimited gain by risking 100% of allocated funds. In the same tutorial you will see that options seller's gain is limited to 100% of premium received for selling options short while losses are unlimited. Does not look very attractive for an options seller. However, this is theoretical statement - it is correct but theoretical.

We discussed above and the reality is that both option seller and option buyer may lose only 100% of allocated funds. Now, lets look at the odds of a success of an call buyer and put seller. Both of them would be opening a trade under bullish expectation for an underlying stock. However, to be precise

  • When you buy call options you will profit when an underlying stock moves up. The stronger up-move, the more you win. If underlying stock moves side-way or down, your call contracts lose their value. The more time you hold your position, the more your calls lose in their value - this is the nature of options.
  • When you sell short put options you profit when an underlying stock moves up - the same as with buying calls. However, you profit also when an underlying stock moves side-way - options lose in their value with time. You even profit when an underlying stock decline for as long as the stock price stays about your puts strike price.

As you may see the investment rule "Higher potential profit comes with higher risk" remains correct when it comes to options trading as well. Because of time decay, an options seller's odds of having successful positive trade are much higher. Yes, an options seller potential profit is limited by a premium received for selling options short, however the odds are on his side. His success rate is much higher than when it compared to an options buyer.

Because of higher odds of having positive trades, the real risk of selling options short is much smaller when it compared to the risk involved with buying options.

That is why services dealing with selling options short may show such high accuracy:
http://www.options-trading-system.com/statistics.asp
Only 3 out of 99 signals over the past 5 years are reported to be in red - this is a realistic picture by taking into account the odds favoring the options sellers.

Real Profit

When we look at the
http://www.options-trading-system.com/tradehistory_recent.asp
we may see some great numbers. However, we have to understand that these numbers are based on the premium for selling options short. We have to understand that this is marketing trick (the guys have to attract the customers somehow). Yes, these numbers are correct when it comes to premium. However, the reality is that there is a high margin and when it comes to real trading you have to allocate big margin - premium will look small when it is compared to margin.

I used the CBOE margin calculator at
http://www.cboe.com/tradtool/mcalc/

According to this calculator you would require to allocate around $16K to be able to sell short 10 QQQ put options contracts with $110 strike at the current market condition (QQQ is traded at $118). This would deliver you $350 premium ($0.35 premium currently is given for 1 put options contract). Now, if this option expire worthless then the maximum profit will be $350 which is about 2% from the overall allocated margin funds. Therefore, when you see 100% profit from the premium for selling options short, you have to reduce it to 2% at least when it comes to total allocated funds. The same with 100% loss.

In this example you will make 2% if the QQQ is not traded less than 6.8% from its current price on an expiration date. It does not matter whether QQQ moves up or down, for as long as it is traded above $110 aont the expiration date, you have 2% profit in your pocket.

As you my see the real profit is not very big, however, the odds are high you will have it. Returning back to the QQQ example above, we may say that the odds of QQQ staying above $110 on third Friday of October are much higher than the odds of happening otherwise.

Conclusion

  • Reality is that selling options short is not as risky as options tutorial tells you.
  • Reality is that when you sell short deep out of the money options, the odds are high you will keep the premium as profit on an expiration date. However, you should not expect more than 1-2% profit from the margin funds allocated for uncovered options,
  • You can mimic the options-trading-system.com easily. The question is how deep out of the money options are you selling. The deeper out of the money options you select, the higher odds of you winning, yet, the smaller premium is. The art is to find (calculate) the out of money strike price which delivers reasonable premium at reasonable risk.
  • If you are not greedy you can make 1-2% a month at relatively low risk which can deliver 12-24% a year of income.
  • If you have $2K in your portfolio, uncovered options are not for you. You will be able to sell small number of option contacts only. Even you have successful trades, brokerage commissions will eat all the profit.

At the end,

  • If you have $30K and more and margin allows you to sell short 15-20 option contracts,
  • If you do not know where to invest these funds,
  • If you have no resources to do a deep analysis,
  • You are not greedy and you are OK with 12-24% returns a year

then you may consider selling options short.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.