Option Writing there comes a very small possibility of a big loss – This puts an end to consistency and profitability.
Shubham Agarwal
Option selling a.k.a. writing is naturally successful trading activity. However, many traders find it difficult to maintain consistency. The reason is, that with Option Writing there comes a very small possibility of a big loss. The possibility could very well trap many writers, who may have a nice three to six month run, but then see losses in the seventh month supersede the profits made so far. This puts an end to consistency and profitability.
Let us try to evade these infrequent events of loss that add to inconsistency, with following three essentials.
1. Always be positionally hedged: Losses if contained at a point can always be managed. When it goes beyond a point it creates a dent that eats into profit more than it should be. For this, there is a very simple rule of thumb. No one will let the Writing Trade lose more than it can make. Most of us do not go beyond stop loss of double the premium received.
However, these stop loss trades do not even get a chance to get executed if the underlying opens with a price gap crossing the stop loss levels. So, the first must-have is that wherever one has a writing trade that needs to get carried forward overnight. Hedge with buy position in farther option.
Buy a Higher Strike Call against Call Sold
Buy a Lower Strike Put against Put Sold
Strike selection will define the premium we pay for buying the hedging position and to what extent are we expect the loss to be contained. Farther the strike lower will be premium payment but higher will be the maximum loss. So, one can choose based on the risk appetite and choice of return compromise for buying the hedge.
2. Opportunity based v/s Calendar based: There are many of us who would use Option Writing as a consistent income generator. There is no argument there. However, for these consistent returns it is not necessary to write options on the first day of every expiry.
It is essential to gauge the opportunity before Writing Options. This means:
• Avoid the Period that has Events in the underlying
• Choose close to Expiry periods to Write Options (Drop in premium due to time value is higher)
• Avoid Option writing when the index or stock is close to multi-weeks low or high
Apart from this there are a lot of systems that could tell us when to write, but if we avoid the aforementioned known risks, it could add to the consistency and many accidents can be avoided.
3. Dysfunctional risk removal: This is very simple. When we sell an Option for premium of 100 the risk is justified but when the same Option drops down to 5, it is not worth the risk. Primarily because we have made 95 percent of what we could make out of the trade.
Everyone have their own rules but for me, I have always kept a 90 percent threshold. I have no intention of making my sold Option go to zero. As soon as I get 90 percent of premium, I buy the Option back. This is because momentum can hit at any time. Any risk of loss after this is dysfunctional.
These three methods have worked best for me in making sure that there are no big accidents and my consistency is carried on in Option Writing for longer period of time.
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