An Unnecessary Warning

I enjoy participating in online discussions concerning options, and frequently visit and post at online forums.  I recently encountered a suggestion that was so absurd, that I thought the poster was attempting to make a (poor) joke.

Nope.  It turns out that he was serious.  I hate the idea of publicizing his idea, but am doing so just to be certain every reader of this blog understands options well enough to run away – at warp speed – from anyone who suggests that you consider adopting a strategy that is in any way similar to this (I have no polite adjective to insert here) poster's idea.

I'm sure this warning is unnecessary, but just in case…

The idea?  On expiration day, sell 10,000 options that are 'way out of the money' for the princely sum of $0.01 each.  Yep, that's a total of $1.00 per contract – before commissions are deducted.

This joker believes that trade yields a profit of $10,000 per expiration – and apparently thinks it's free money.  He actually calls this 'guaranteed way to make big, risk free money in options.'

Reality:  Selling very cheap options is a losing strategy.  Sure these options expire worthless almost all the time.  Just think about the one time when this turns out not to be true.  Stocks can, and do, make major moves in the final few minutes of trading on expiration Friday.  Attempting to make such a tiny amount of money is financial suicide.  Think about the loss if just one of these trades results in an option moving into the money.  With 10,000 contracts, that costs $1,000,000 per point.  Not only that, but can you imagine how your order to buy 10,0000 (now in the money) calls is going to affect the price of those options when the stock price is surging?

I understand this is an idea that will attract no followers.  But what I fear is that someone might think it's a good way to pick up a few extra dollars by selling 10 or 20 contracts.  Please don't do it.  And if the price is $0.05 per contract, the idea is no better.

By the way, the margin requirement for selling naked call options does vary by broker, but a reasonable minimum is $250.  (Many brokers do not allow the sale of naked call options under any circumstances.)  Thus, it takes $2,500,000 to meet the margin call on this play.  Do you think anyone who has two and one-half million dollars worth of free margin would jeopardize his/her account in an attempt to earn peanuts* ($10,000 less commissions)?  I don't.

* Peanuts for that investor, not necessarily for the rest of us.

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10 Responses to An Unnecessary Warning

  1. slait73 02/23/2009 at 1:13 PM #

    Dear Mark,
    Today I´m trying to buy an IC on May expiration date.
    As I can see there is very few volume on every strike) on that month and I can´t imagine the reason. Sure you got it.
    Also I buyed this May 09 IC: 570/580/330/320, for 2,25 credit. What I wonder is that it is woth to sell the call vertical, because I´m bein paid 0.15 and may be it´s an small premium for so much time.
    Recuerdos desde España.

  2. Mark Wolfinger 02/23/2009 at 1:30 PM #

    The reason thee is very little volume in RUT May Options is because this is the first day they are listed for trading. The May options replace the Feb options, which expired last Friday.
    Volume will increase as the days pass.
    Your instincts are correct. Fifteen cents is far too small a premium for May options (as far as I’m concerned it’s also too small for March options).
    1) You have to trade positions that are comfortable for you, but the position you own is NOT comfortable for me.
    2) If I were short ANY May spread, I’d gladly pay $0.30 to buy it back. That does not mean you should do that, but it does mean that I suggest you NEVER sell spreads for such a small amount as fifteen cents. My philosophy is to buy back all spreads when they get cheap. To me, that means $0.35 or less, depending on how much time remains.
    3) If you do NOT want to sell calls at a lower strike price, then I suggest you sell only the put spread and ignore selling the call spread. You may get a chance to sell a call spread later, if the market rallies. Selling nothing is better (in my opinion) than selling for $0.15.
    If you want to do a true iron condor, then you want the call spread and put to be approximately the same distance out of the money. The calls you chose are much further.
    If you see my Twitter posts (user name: MarkWolfinger), you will see that I traded some May iron condors today. But, I’m selling calls with a strike price near 500, and you are trading strikes near 600.
    4) There is not much you can do about this now, but you should have been able to see that the call spread was going to pay a VERY small premium – before entering your order.
    When choosing the iron condor, I suggest looking at the markets for the call spread and put spread separately – just to be certain they will each contribute some cash to your total premium. Once you verify that the prices are not that different ($1.00 and $1.50 is good enough; $1.00 and $2.50 is not a good iron condor – for my comfort zone).

  3. slait73 02/23/2009 at 1:59 PM #

    Mark,
    Thaks a lot. Don´t worry about me, it´s just paper but I apreciate a lot your comments. Step by step, it´s the learnig process.

  4. Mark Wolfinger 02/23/2009 at 2:06 PM #

    Agree. Step by step.

  5. slait73 02/23/2009 at 2:29 PM #

    Sorry to bother you but I got to ask you abot the philosophy of your last IC. In your book you say you look for 2 or 3 front months which is what you have done, but you also say that you expect to be paid beetwen 3 to 4$. I´m wondering about the reasons you take the trade with less premium…it´s because volatility?…

  6. Mark Wolfinger 02/23/2009 at 2:52 PM #

    Good question.
    I’m taking less because I am afraid. I am willing to settle for a little less than $300 and be comfortable than get my $350 and feel less secure.
    I’d rather have a bit less cash and sell options that are further out of the money.
    But this can only go so far. I would not trade iron condors that are very far OTM – just a strike (or two) further OTM than I usually sell.

  7. GMG 02/27/2009 at 8:29 AM #

    I saw that post, and unfortunately I don’t think the OP saw how you were trying to help him/her. Actually I’ve seen several threads on that board where you’ve tried to steer people away from the cliff and the usual response seems to be anger. They accuse you of being jealous for not seeing the genious of their strategies…pretty sad. But I guess some people just need to learn those things the hard way.
    http://www.despair.com/mis24x30prin.html

  8. Mark Wolfinger 02/27/2009 at 8:49 AM #

    How can I argue with the idea that everyone thinks he/she knows better than everyone else? I had plenty of warnings about risk as a new market maker (1977), but thought I knew better.
    Experience is truly the best teacher – but only if you survive the learning process.
    Thanks for posting

  9. whatismyoption 03/01/2009 at 4:41 PM #

    Hi Mark
    I totally agree with your post and think the warning in necessary. You pointed out the dangers; I’d like to to extend the time frame a little. Options exchanges have a cut-off time of 4:30 pm Central Time for exercise (last trading day). So selling these OTM options leaves you exposed to any announcements up to that time. Imagine a takeover announcement after markets close and the stock opening $20 higher on the Monday, say $10 ITM. That would have a $10 million cost to cover. I have read about many smart traders who were wiped out in their early days by just this sort of thing.
    Great work highlighting this Mark. Love your blog.
    Dean – http://www.fusioninvesting.com/

  10. Mark Wolfinger 03/03/2009 at 3:42 PM #

    I also remember takeovers killing the call sellers, but I don’t recall one being announced just after the market close on an expiration Friday.
    But it surely could have happened.
    Learning to buy back those penny options, and especially not selling them in the first place, is just something that a few individual investors are going to have to learn for themselves.
    Thanks.