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Managing Option Selling Risk

One of the most common questions I get from new clients starting their option selling portfolios is “How do we manage our risk (protect our downside, limit our exposure, et..)?
It is not only a fair question; it is probably the most important question you can ask. In an investment where 85-90% of your trades should statistically be winners, your results at the end of the year will depend heavily on how you handle the other 10-15%.
Managing risk or handling losing trades is not something you should have to worry about. There are simple, effective ways to do this with short options and all that it requires is a plan.
That is what this week’s seminar is about.
As is true in most areas of life, an ounce of prevention is better than a pound of cure. The same holds true to managing risk in your option selling portfolio.  As we have covered in past tutorials, how you structure your portfolio can have a big impact on your exposure. If your portfolio is structured correctly from the start, managing risk on individual positions becomes easier.
To Review
1.      50% of your portfolio should be held in cash. This gives your account a large cushion to absorb any potential margin increases in your positions.
2.      The remaining 50% should be diversified over 6-10 uncorrelated commodities markets. By structuring this way, if a position should run on you, it will encompass only a small percentage of your overall portfolio. (Recall the submarine example: The hull is comprised of many different compartments. Should a hole be punched in the side of the sub, the compartment can be sealed off, isolating the hold and protecting the rest of the ship. This is how your portfolio should be built).
3.      Sell Options Deep out of the Money. This allows you to manage risk based on the value of the premium without worrying about when or if your option will get assigned.
If your portfolio is set up this way, your risk management plan is already half done.
Assuming that you are structuring correctly, we now arrive at the answer that everybody wants to hear. Where do we get out? Before I answer, lets include some of the related questions that come with this so we may address them all at once.
What if we get assigned?
Do we offset with a futures position if it goes in the money?
How much would we risk on each position?
What is the “rule” on exiting?

Investors like hard, fast, solid rules. They like things quantified. They want to know exactly what to expect. 
Unfortunately, investments are not like that. It is a good idea to have rules for any trading plan. However, add too many rules and your approach becomes inflexible and ultimately, ineffective, unable to capitalize on moving opportunities. Because of this, I like to call my trading rules “guidelines.”
And my guideline is this: If the option doubles in value from the point at which you purchased it, buy it back. Exit the position. (This is known as the “200% rule” for those that read The Complete Guide to Option Selling.) Do not try to “delta neutralize it” or offset it with a futures contract or anything else. In my opinion, the best approach is a simple one. The option doubled. You were wrong. Get out. Move on. Follow the guidelines laid out above and you should be able to recapture that premium somewhere else.
As listed above, our portfolio strategy sells only deep, deep, deep out of the money options. Options that are not going to go into the money (at least not for a long long time). This allows you to manage risk based on premium value. There is little concern about where or when it will go in the money or if it will be exercised. It’s too far away. Again, simplicity.
This is the guideline I recommend if you trade on your own.
Do I always follow the 200% rule in the portfolios I manage? No. I use it as a guideline – a hazard light, if you will, to let me know that I need to address our exposure. In deciding when and if to fully or partially exit a position, I also take the following into consideration:
-         How long until expiration?
-         How large is this position in regard to the overall portfolio?
-         Is it hedged? (ie: If it’s a call, do we have puts on the other side of the market?)
-         Wildcard: What is causing this to move against us and is it likely to end soon?
I would call these 4 items “advanced risk management” questions because I would not recommend them to a beginner or even moderately experienced option seller. These are for the highly experienced trader as how you use them is almost always based on judgment. And that kind of judgment takes time to develop.
Nonetheless, if an option we’re holding doubles, it’s a pretty safe bet that our investors are at least scaling back the position in some way. If you are selling options in your own portfolio, it is my opinion you would do well to follow the 200% rule at all times.
Remember, in option selling, the winners take care of themselves. The main account management you have to do is cut short the losers. Set up your portfolio properly, sell deep out of the money and follow the 200% rule. Its the best advice I can give for building a rock solid, high yielding portfolio while allowing you to sleep well at night. 
To learn more about investing in a commodities option selling portfolio, be sure to request your Free Option Seller Information Pack at .

Disclosure: no positions in stocks