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One Big Risk When Trading Options: Not Quite Understanding the Details

Here is my delayed response to Bill's question (from Jan 28).

Mark,

My concerns about the strangle options play [Note: he's referring to selling strangles] is that it just seems
too simple, and that I may be missing something important. 

It is simple.  Just sell some options.  That's all there is to it.  But it's quite risky with potentially unlimited losses.  We both recognize that 'unlimited' is just a word and the stock is rarely, if ever, going to drop 50% or double overnight.  But losses can be large when compared with potential profits.

My gut
feeling right now is that my constant vigilance and a plan to modify or
exit the strangle in the case of an extreme move will provide me with
adequate safety in my efforts. I'm also selecting very high-quality
stocks which have a history of slow and narrow moving ranges, and which
will not be reporting earnings during my holding period. Also, my
strangle positions individually will represent not more than 5-6% of
the portfolio total value, so any one position is not going to destroy
things on its own if it turns bad and out of control. 

Those position attributes go a long way towards the low risk you seek.  But that does not take away from the fact that you are selling naked strangles.

Here's my short
list of questions: 

It may be a short list, but there is no way I can help you with a short reply.

1. I had assumed that an option which reached its
strike price would be subject to assignment, and would be from the "in
the money" direction; if this is true then does it mean that my "out of
the money" strangle positions are automatically subject to possible
assignment, from the outset? 

a) You assumed incorrectly.  I am always surprised when someone comes to me with this (or similar) question.  No one in his/her right mind would EVER – under ANY REASONABLE CIRCUMSTANCES – exercise an option when it 'reaches it's strike price.

I just cannot comprehend from whence that idea originates.  I would be extremely appreciative if you can provide a clue.

Just look at any stock and the options on that stock.  Notice that there are in-the-money calls and puts.

Notice that the open interest of these options is not anywhere near zero.  Zero would be the open interest if everyone exercised those options.

Keep in mind that just because you sold the option when it was out of the money and discover that it has move to become at ATM or ITM option – does not change anything.  It's now an ITM option like any of the other ITM options.  Those other ITM options were not exercised by their owners.  Yours will not be exercised either.

If they are not exercised, then you are NOT subject to being assigned.  Sure it can happen once in a lifetime, but get it out of your head that you are subject to exercise. And if you were assigned an exercise notice, it would be a major gift to you.  When an option is exercised, all residual time premium in that option is forfeited.  In other words, you get to buy that option at parity.  What a bargain price!

Your question tells me that you are an intelligent person, so I assume this is crystal clear to you,  What I don't understand is where you learned that you might be assigned under these circumstances.

Just take a look at that option data I had you look at earlier.  Do you see that the slightly ITM calls and puts carry a time premium in addition to intrinsic value?  Anyone who owns that option and no longer wants to own it – would SELL and collect the full option premium.  Exercising allows the capture of only the intrinsic value and the time value is tossed into the trash.  No one would do that.

b) NO.  Your OTM options are not going to be assigned either.  I grant that the option owner has the right to exercise at any time, but would never do so.  NEVER.

That does not mean they cannot be exercised when expiration arrives – if – at that time they are no longer out of the money.  But that's not what you asked.

c) Look at this from this perspective. A stock is trading at $36.  You sell a 30 put and a 40 call and collect a total premium of $200.  The next day you are assigned on both options.  What happens? 

You must sell stock at 40 to the call owner.  You must buy stock from the put seller.  You sell @ $40 per share and pay $30 per share.  In addition to the $1,000 profit, you keep the $200 premium.

What do you think the probability is for that to happen?

d) Let's go further.  let's say you sell ITM options as your strangle.  Although this is done by few traders, it's referred to as selling the 'guts' strangle.  You sell the 40 put and the 30 call.  You collect a premium of $1,200.  When assigned on both options – either today, tomorrow or at expiration, you sell at 30 and pay 40.  That costs $1,000.  But you were paid $1,200 and have a $200 profit.

That is not going to happen tomorrow.  There is no reason to exercise any option that has residual time premium.

e) One more perspective:  You can buy stock at $36.  Would you pay $7 for the 30-strike call and then immediately exercise it?  Of course not.  That would be equivalent to paying $37 for stock.  No one is going to do that.


2. I don't feel any particular fear from
being assigned; my brokerage just shorts my account (I don't have to
actually hold the underlying) and then I would manage it as a short
position of a common stock–it could actually yield additional gains if
this happens in a down day of course–but even if it's moving up in
price a quick "buy to cover" removes the issue with minimal losses.

I
understand the issue of potentially disastrous losses if some unusual
event were to occur which would move the underlying price at an
accelerated rate–and this is why my position size is intentionally
small as stated above.

a) There is no reason to fear assignment. In fact, you can only benefit and essentially never lose.  Instead of being short a call worth a few bucks, you are short stock.  If the stock rallies you have lost NOTHING.  Being short the call gives you the identical upside risk.  Identical.

So, if you must do a quick 'buy to cover' with short sock, you would be forced to make the same trade (by to close on the call).  You lose NOTHING extra.

b) And if the stock tumbles below the strike of the call, then you make more on being short the stock than you would have earned by being short the call.  Having been assigned an exercise notice prior to expiration (and those are the scenarios we are discussing – or at least I hope so) turns out to be a free gift.  Essentially you get to buy back the call option for 'less than zero.'  Example: Sell a 50 call and collect $300.  Maximum profit: $300.

Assume You receive an assignment notice and the stock drops to 48.  You buy it back.  You made $300 from the call and an extra $200 on the stock.  Maximum profit just moved above that $300.  Being assigned early was a true gift.  No possible losses and possible gains.  If you understand equivalent positions, then you were given put option at no cost.

c) But your statement about minimal losses, or disastrous events, tells me that you don't recognize that being short the stock is better than being short the call.  there are no 'minimal losses' associated with being short the stock.  You incur the same losses when short the call.  You must understand that. You are trading options and you must understand what is risky and dangerous and what reduces risk and is beneficial.

d) Good idea – about position sizing.  It's one excellent method for controlling risk.


3. The issue of actual selection of expiration
and strike price is a little mysterious to me–in the way that it seems
so simple.

I'm using the nearest expiration date (Feb 20 right now) as
my expiration of choice because it allows me to roll the funds over
into the next expiration with the highest frequency; the reduction in
premium compared to a longer expiration date is minimal and I also like
being able to count on a probable smaller move in the underlying during
the shorter period.

Regarding the strike price selection I'm simply
using the furthest strike price available from the current price of the
underlying; this yields the highest premium and minimizes the
possibility of the underlying striking my holdings.

Currently I've sold
3 Feb HAL 36 puts and 3 Feb HAL 25 calls; price of the underlying at
this writing is 29.53 and the 90-day highs and lows are 34.87 and
25.50.

The first question to be answered is, am I making some kind of
gross error in my assumptions?

Please feel free to fire both barrels at
me if I'm in over my head here!

Thanks in advance for taking the time
to help me out.

Bill


a) I would never shoot both barrels.  My goal is to help you understand how options work.  If you are making a mistake, I want to help you correct it, not make you feel worse. I do get frustrated by some of the questions I receive, but I can tell by your specific problems that you did not learn about options from this blog or The Rookie's Guide to Options.

Choosing the expiration date is not a 'who cares?' decision. It's important.  Rolling funds with the highest frequency is not always a good idea.  It most certainly makes your broker happy because this method assures that you pay he highest possible amount in commissions.  Not only that, but if your broker charges you anything for exercises or assignments, then you are paying a bunch of extra fees.  I hope you are comparing annualized returns on your profits (when you earn them) and comparing what those returns would be if you traded options with a longer lifetime.

Yes, shorter-term options have less time for something to go wrong, but when you consider than trading a one-month option three times costs you thrice the commissions and thrice the assignment fees, does it still give you the results you desire?

Don't forget this: less time and a lower probability of a big move means that the premium collected is also less.  Often so much less that it's a very bad trade.  And my guess it that you made very bad trades. But because you did not share the premium collected when asking your question, I can't know that for a fact.

In addition to telling me which options you sold, I would have like to know how much you collected to sell them.  And what you pay in commissions and assignment fees.

b) All I can say about your strike price selection is OMG.  Are you serious?

Collecting the 'highest premium' means nothing.  In fact it means less than nothing.

Please think seriously about this question:  Do you understand how to make money by selling options?  It is not from selling the most premium.  It is from selling the most 'time premium.'

Your trade is EXACTLY EQUIVALENT (same profit and risk of loss) as selling the farthest OTM call and put.  That's what you are doing.  It's the same thing.

c) Are you making some gross errors in your assumptions?  I'm glad you asked because that is the ONLY question that matters. I cannot tell you – but I am going to tell you how to figure it out.

Let's examine the HAL position.  You sold the 36 put and the 25 call.  When expiration arrives and you are assigned an exercise notice, you must sell stock @ $25 and buy stock @ 36.  That will cost you $1,100.

How much did you collect when selling the strangle?  Obviously your profit is the amount ABOVE $1,100 that you collected, less commissions and assignment fees.  I have no idea how much that is, but I'd guess that it's not much above zero.  I'd guess that you are taking the risk of something bad happening for almost no compensation.

By the way, when you enter your orders to sell the call and put, I hope you are entering the orders at a spread, and not as single orders. It's also essential that you set a limit price and NEVER, under any circumstances, sell the strangle 'at the market.' That would be a a very poor decision.

But I have no idea if this was a bad trade.  I'd bet that you collected less than $1,100, guaranteeing a loss.  Only you how much you collected when selling the strangle.

d) There is one problem with selling the guts strangle that I ignored above.  When the stock pays a dividend, it is VERY likely that you will be assigned an exercise notice on the call option one day prior to the stock's ex-dividend date.  That means you must pay the dividend.  When that happens, be certain to subtract the cost of that dividend from your profits (if you have any). But, more than that, some brokers charge interest for you to be short stock.  Years ago, they paid a rebate when short stock.  That is no longer true.  So subtract those interest charges from your profits (if any).

e) When I mentioned above that nothing bad happens when assigned an exercise notice – that's almost always true.  You may have an interest charge to pay.  Verify with your broker whether they charge interest when you are short stock.

f) It's my pleasure to help you out, but your question – and my reply – has brought to the surface a problem that has been developing for awhile now.  I'll have more to say about that in Friday's post.

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