I Have Been Selling Naked Options For Income

By David Goehring @http://www.flickr.com/photos/carbonnyc/5747629074/

09 Jul I Have Been Selling Naked Options For Income

I have been keeping something from you for 6 months.

I like to share openly with BFP readers but I decided not to disclose this until I am ready. Don’t get me wrong. This is to ensure your safety because it is a risky endeavor that I do not want to entice you into doing it.

The truth is – I have been selling naked options for income. Selling naked options means I am betting the options price will go down and I do not own the underlying assets. There are a few factors that affect options price such as the underlying asset’s price, volatility and time decay.

Statistics show that most options expire worthless by their expiry dates. That is why selling options has high probability of winning.

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But high probability of winning alone does not mean it is profitable. It is about having a positive expectancy and this includes the average winning and losing size on top of the probability of wins. You can read more about it here and here.

Options is one of the most complex and least understood asset class in the financial markets. The most popular figure of anti-options-selling got to be Nassim Taleb. I have great respect for him and he said that options are often mis-priced due to miscalculation of the tail risks by the conventional options pricing theories.

In fact, he said it was impossible to price the tails because nobody can predict the future, and nobody can accurately calculate the probability of an unexpected event. As such, he likes to buy far out-of-the-money options. He is betting for rare but impactful events to happen. In fact, he thinks it is not as rare as what people think it is.

Jon is the biggest Taleb fan I know. He doesn’t believe in options selling totally. I told him I am going ahead to sell options even if he disagrees. I am going to do it even though I agree with what Taleb said. I explained to Jon that all forms of trading and investing are all about risk management.

Yes, options payoff are non-linear which is unlike traditional linear payoffs from long-short equity strategies. However, it does not mean you will not blow up your capital if you long or short shares. Every trader and investor needs to practise risk management because there is one trade out there that will wipe you out, regardless if you have total conviction about being right.

So what is the difference between selling options or any other strategies? I see one similarity rather than differences – all are risky. I agree with Jon I am picking pennies in front of the steamroller. But this is similar to scalpers, swing traders and trend followers. I will try to jump away from the steamroller as fast as I can so that I can continue to pick the pennies. Jon questioned my overconfidence in jumping off in time and I admit I stand a chance to blow up, without a doubt. And if I do, I hope he will pick me up from there. :)

I learned options selling from Dave Foo – whom I interviewed on Secrets of Singapore Trading Gurus (do not bother searching for his video, we did not film it). He has been selling options for many years and he was able to get 5% returns per month. I thought his method was simple to implement but I was surprised to hear that he asked the class not to put too much capital for a start so that we can make all the mistakes at minimal costs. He also said to give myself six months to get familiar with options selling.

I started with US$20k as my initial capital and I increased the capital to US$40k and eventually US$50k within these 6 months. How did I performed? If I tell you I only have winning trades and a happy life ever after, I must be kidding you. Likewise, if anyone tell you it is all profits, he must be kidding you big time. Dave was right, I did make mistakes and I realised how costly it is. Let’s look at the performance and I will go through the mistake in detail.

  • Jan 13: +US$708.75
  • Feb 13: +US$883.12
  • Mar 13: -US$567.51
  • Apr 13: -US$9,072.49
  • May 13: -US$890.02
  • Jun 13: +US$1,333.13

Apr 13 was a BIG OUCH! I had a 25% drawdown on my capital. This was where I truly understand Dave’s words about starting with a small capital and make the mistakes in the first 6 months. In Apr 13 alone, I made all the mistakes I could. First, I miscalculated the strike price and got in a trade that I should not have taken. That cost me a US$2k loss. Second, I did not manage to cover the loss for the gold trade because I was away in Taiwan.

By the time I checked my positions, I was down US$5k. It was just past US trading and the market liquidity was thin. The price spread was wide and I was not able to get a good price to fill. But I could not wait until the liquidity come back as I might not have any internet connection to check and I do not want to worry about the position during the trip.

Hence, I cut loss and covered the position at a bad price. I should not be so complacent that I can afford not to monitor my positions closely. I deserve the loss totally and there is no excuse about that. The market is cruel when you are careless.

The Apr trades also taught me the importance of capital preservation. Losing US$9k meant I need many months of profits to get back even. This one month alone is good enough to warn me the chance of blowing up if I do not manage the risk properly. It humbled me. In the middle of May, I tighten the risk management rules.

Instead of rolling trades like what Dave suggests, I prefer to cut the loss fast. And instead of taking a risk-reward ratio of 3:1, I have reduced the risk-reward ratio to 1:0.7. I had 3 losses in Jun alone and I managed to contain them, below US$800 for each loss, and edge out a profit of US$1.3k for the month.

My purpose of telling you all these is because I want to show you the reality of trading and to convince you how hard it is. A lot of people are lying to you how much money you can make from trading. I want to tell you the truth. I want to show you my struggle. I don’t care if people would laugh at me and my losses.

I will continue to trade and stick to the risk management closely. I will let you know the results in later part of the year. If such big losses happened again even though risk management is followed properly, that means this strategy has no positive expectancy.



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28 Comments
  • Chris
    Posted at 13:47h, 10 July Reply

    Alvin,

    I do experienced the down side of Gold (GC). If you want to limit the loss by apply Bull Put the losses will be limited.

    I total agreed we can’t avoid the down side of GC, I did a Strangle for Call / Put for the underlying it recoved some money from the market.

    Rgds,
    Chris

    • Alvin Chow
      Posted at 19:12h, 10 July Reply

      Hey Chris, nice to hear from you. As an options trader, would you like to share how you manage the risk?

      • Chris
        Posted at 13:01h, 11 July Reply

        Alvin,

        By selecting the future underlying, we look at 1 year HH, LL trade beyond the size , we can call it as safety zone.

        For the underlying move above HH or below LL it has to take greatest market to do so.

        Naked Call / Put is no no for me, to reduce the risk, you can either Short Call with next higher Long Call or Short Put with next Lower Long Put.

      • Chris
        Posted at 13:24h, 11 July Reply

        Margin for Naked is much greater than Bull Put Spread / Bear Call Spread. You can make good use of the margin looking for other underlying to generate income.

        Delta – look for delta 0.1 or probability > 90%
        if the trade move against you delta >0.3 to 0.4 prepare to roll up / down your position.

        • Alvin Chow
          Posted at 19:35h, 11 July Reply

          I understand where you are coming from. Doing Bull/Bear spreads will utilise less margin than naked. Currently, I am looking for delta 0.05. Let me trade and see how to tweak it along the way if necessary. Thanks for your sharing.

  • YS
    Posted at 13:47h, 10 July Reply

    Hi Alvin,

    Thanks for sharing your results! I tried options trading back in 2008 as well, and promptly lost quite a fair bit of my capital as well. It just brings us back to earth doesn’t it?

    Press on in your trading journey! Never stop learning! :)

    • Alvin Chow
      Posted at 19:13h, 10 July Reply

      Thanks YS for your encouragement! There’s so much to learn!

  • Shawn
    Posted at 17:32h, 10 July Reply

    I enjoy reading your blog but i think it is worth correcting a misperception, or maybe a misinterpretation here. Statistics do NOT show that most options expire worthless. CBOE statistics show that around 10% of options get exercised.

    While exercise implies that the option is in the money, it does not imply that the rest that do not get exercised are out of the money.

    Around 55-60% of options get closed out before expiry, that means these option positions get trade out of, and this also begs the question that when the option is traded out of, where do the profits go – buyer or seller?

    So actually, only about 30-35% of options expire worthless. I am not making any judgment about whether selling options is the right strategy or not, but making a point to correct a very common fallacy. Risk management is imperative – however i think the returns from Jan-13 to Jun-13 illustrate clearly why selling options can be dangerous – because your downside is unlimited (sort of) and upside is capped.

    Cheers! Stay safe!

    • Alvin Chow
      Posted at 19:16h, 10 July Reply

      Thanks Shawn for your explanation. I agree with you that selling options may not be a high probability game if we dig into the statistics deeper.

      I will give the strategy some more time and continue to trade it. We shall see if there is positive expectancy.

      Thanks for your blessing!

  • ryan
    Posted at 17:39h, 10 July Reply

    Hi Alvin,

    Writing options naked is very ballsy endeavour. To say that its like picking pennies in front of a steamroller is an understatement. More like picking pennies in front of an F1 car. Because it can hit so fast, we have no room to think let alone analyse. However I must applaud you for your openness to experiment and learn, even in an uncomfortable and new territory.

    Cheers.

    • Alvin Chow
      Posted at 19:17h, 10 July Reply

      Wow. I like your description! Picking pennies in front of an F1 car. :D

      And I really appreciate your kind words. Indeed, I think very few traders show their real results. Transparency is definitely lacking in this game.

  • Value Investor
    Posted at 22:40h, 10 July Reply

    Alvin, thanks for sharing. It is hard for people to share about their mistake, only gracious people do that.

    Coincidently I just started my sell option trading as well. I know that we cannot afford to make mistake in option trading because if you have losing trades, the capital losses will certainly be more than the option premium.

    So to mitigate my risk, I look for stocks that are trading below book value, has aggressively insiders’ buying, better if they have share buybacks. So even my options get assigned, I do not mind holding on to the stocks.

    My option trades:
    http://tradingeducationprogram.org/2013/07/03/sold-citigroup-and-genworth-options/

    • Alvin Chow
      Posted at 06:55h, 11 July Reply

      Hey BL, thanks for the comment and your sharing. I mainly sell options on futures and not options on stocks. It will be interesting to discuss about the similarities and differences between the two. We should catch up sometime.

  • Richard
    Posted at 09:21h, 18 July Reply

    Hi Alvin,
    Came across your blog. Thanks for sharing.

    I am a full time US equities traders from Singapore. I do use options to trade sometimes, depending on situations. Case in point, using Call options for first hour scalping on TSLA last night (17-Jul-2013) would be great. Selling options is one those things when I do too. But very very seldom I sell naked Put/Call options. I only sell option when I want to own the stock itself. I rather make lesser but with well-defined risk with spreads. Risk is a very real thing in trading and we have to manage it.

    I am not saying that selling naked options is not a good strategy, but just that you have to manage black-swan events. All the small gains made will be wiped out in just one single trade if such events were to happen. For example, traders selling naked Put on ISRG would have taken quite a big hit recently. So I rather do a vertical spread or iron condor (if the price action permits).

    How do you select what stocks to sell options? Do you take into account volatility? One easy way for novice is to look at the Bolllinger Band.

    Richard.

    • Alvin Chow
      Posted at 10:10h, 18 July Reply

      Hey Richard, great to know another trader out there. It is indeed risky to do naked shorts.

      To manage risk, I usually short options only when volatility is high. Otherwise, I do not do anything. It is safer to wait for price to move fast and hard before shorting, and bet that price will revert to the mean or volatility would drop.

      There is so much flexibility with options and I think there are many ways to profit. It would love to understand how you trade too.

      • Richard
        Posted at 12:09h, 18 July Reply

        How do I trade options? It really depends on different situation and I will apply different strategy. Maybe we will just state some examples here to make the discussion easier.

        For example YHOO announced great earnings yesterday and the stock is up 10%. Honestly, I missed this move as I was riding TSLA. Personally, I would sell naked Put strike price $27 on YHOO because I want to own it at around $27. I think chances of YHOO coming back to $27 is slim, unless the general market corrects. But if really come back to $27, it will be great for me cause I reckon support buying will come in at $27 if not $26.

        Another example, LINE. For this, a higher low has been established at $25, but I see the upside resistance is at $30. So an iron condor above $30 (bearish spread) and below $25 (bullish spread) will be feasible. But I wouldn’t take this trade now because earnings is on 22-Jul. So it’s just for discussion.

        • Alvin Chow
          Posted at 23:43h, 19 July Reply

          Can I say that you would use technical analysis to determine critical price levels which form support and resistance, then use options as a tool to express trade ideas around these levels?

  • Pok Chow
    Posted at 19:06h, 22 July Reply

    Hey Alvin,

    I like your site. Keep doing what you’re doing!

    Like yourself, I’m also an options trader. I think option trading is really underrated. People without any knowledge of it simply label it as “risky”.

    Couple of questions.
    1. How long have you been trading/ trading options?
    2. Do you only sell naked puts?

    • Alvin Chow
      Posted at 19:28h, 22 July Reply

      it is indeed risky. but it is not right to say other forms of trading are less risky. In fact, all are risky and that is why it is always risk management.

      to answer your questions:

      1) 6 months. started in jan 13

      2) I sell both naked calls and puts

  • Pok Chow
    Posted at 20:25h, 22 July Reply

    Thanks for the swift reply Alvin!

    Two more questions!
    1) Any other strategies other than naked options?
    2) What do you do full time? Is it trading?

  • Alvin Chow
    Posted at 22:34h, 22 July Reply

    is this an interview?

    1) I do trend following and value investing as well

    2) no, I have a job

  • 5 Things You Need to Know About Volatility
    Posted at 11:35h, 23 July Reply

    […] his confession two weeks ago, Alvin explains how he sells options for regular income. The gains are small and […]

  • Boman
    Posted at 20:03h, 26 July Reply

    Interesting topic. One of the best sources of understanding options and selling put options can be found on Tastytrade.com. The founder of the site is Tom Sosnoff who founded the trading platform ThinkOrSwim. All the info is free! Makes you wonder why people spend thousands on learning trading strategies when you can just watch Tastytrade.

    • Alvin Chow
      Posted at 11:03h, 27 July Reply

      Thanks Boman for recommending the site. Looks interesting. Will explore it.

  • tank
    Posted at 16:08h, 03 November Reply

    very interesting discussions and great to find that some options sellers here! :)

    i am an options seller too, in both stocks and futures. hope to catch up with you guys one of these days!

    tank

  • How I Blew Up $105,000 In My Trading Account
    Posted at 08:15h, 29 January Reply

    […] second safeguard to risk management is cutting losses. The following was what I wrote in an earlier article, after learning from a loss in Gold […]

  • Elbert
    Posted at 20:11h, 13 August Reply

    Hi,
    Was searching for Options related website and came across your blog.
    Which broker do you trade options with?
    Thanks!

    • Alvin Chow
      Posted at 11:33h, 17 August Reply

      Think or Swim

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