RISK management is important at Foremost. Whether you trade on your own or a professional Commodity Trading Advisor manages your account, a thorough understanding of risk is important. While all trading has risk, different methods may contain different types of risk. The classic trend-follower sees things differently than a spread trader who is entirely different than a day-trader.
An increasingly popular way to trade is by selling Call and Put options. Selling options, however, comes with its own set of risks and, therefore, expectations. Some of our favorite CTAs use this trading strategy: White River Group, Bluenose Capital, Global Sigma Group, etc. Many of our clients have accounts using a variation on this trading style. Let’s recap some these unique risks and expectations.
An important element to option valuation is TIME. Every option has a defined lifetime. Since options represent the right to be long (Call) or short (Put) an underlying asset, the amount of time left significantly affects its value. Options losing their value over time is known as “time decay” and denoted by the Greek letter theta.
Options sellers take advantage of time decay because it works in their favor and against the buyer. The truth is most options expire worthless. And most options lose value at some point in their lifetime. The seller will profit most when their Put or Call option expires worthless allowing them to keep the money for which they sold. The option price is called “premium.” Whether a Call or Put, the seller is looking for their option to lose its premium value, i.e. sell high, buy low.
So why the blog title? The idea of picking up pennies on a train track is often used to give a simplified understanding of the risks involved with option selling.
Imagine you’re on a platform waiting for the train to arrive, and you see a penny on the tracks below. Would you take the risk of jumping down to pick it up? Probably not. But what about a $100 bill? Perhaps. Now what if you knew the train wouldn’t be arriving for 5 minutes? That’s plenty of time to safely grab the money before the train represents a risk. What if you could see the train quickly approaching? How much money would need to be on the train track for you to take the risk of getting hit? This is an over-simplified metaphor that helps communicate the probability of risk and reward in option selling. Before you begin trading, a more thorough understanding of the risks in your trading approach is necessary.
Many CTAs make a living by selling options with little value but a higher likelihood of expiring worthless. This trading approach typically manifests itself in a specific track record. Because they are taking high probability but low profitability trades, the equity curve will show small positive growth the majority of the time. Every so often, however, the “train comes early and unexpectedly,” resulting in potentially devastating losses. Option sellers typically experience losses much larger than their average gains. Those who can easily adjust their positions may be able to limit losses, but others may hear their death knell. However, once they stabilize the situation, the option seller typically starts the slow road toward potential recovery.
A good example of this tendency is shown in the track record for White River Group’s “Stock Index Option” White River Group In the graph below, each green bar represents a month’s performance. You will see that the vast majority of months are positive but small. The losing months, two in particular, while less common are greater in magnitude.
MONTHLY PERFORMANCE (%)
White River Group “Stock Index Option” Program
It is important to remember that because large, infrequent drawdowns are typical, it is not necessarily a red flag when it happens. In fact, prepare for it! If you expect large losses for a small percentage of the time, it should not be a surprise when it happens. No one likes drawdowns, but understanding what a typical drawdown looks like for your trading method is important.
As we mentioned before, some of our clients have accounts traded by professional option sellers (CTAs). If you would like more information about these names and their track records, call your BROKER and visit the CTA DATABASE.
If you’re already participating in a strategy that sells options for premium, make sure you talk with your BROKER about the appropriate expectations for risk and drawdown. Part of our job as your broker is to explain the typical expectations for a given trading method. It is also important to remember that the risks in trading – especially option selling – can be substantial and not are for everyone.
Disclaimer: Trading futures, options on futures, retail off-exchange foreign currency transactions (“Forex”), investing in managed futures and other alternative investments are complex and carry a risk of substantial losses. As such, they are not suitable for all investors. This website contains information obtained from sources believed to be reliable, but such information has not been independently verified and its accuracy is not guaranteed by Foremost Trading. Past performance is not necessarily indicative of future results. Any mention of performance in any context whether actual or hypothetical is no guarantee of future results. Foremost Trading became a registered ‘dba’ of RCM Alternatives in July of 2020. Please see full disclaimer here: https://www.rcmalternatives.com/disclaimer/