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I am not a big fan of naked option selling as a stand-alone strategy. I have
expressed that fact several times on the Internet on different forums and
lists. Most option sellers I have seen over-leverage themselves and
concentrate their positions in to few markets. Or at least the ones that I
have run across lately have. Given that, I ask for clients to be well
capitalized if they are going to pursue such strategies, and even then I am
picky about which clients I will accept.
There is one trading guru who has selling options as part of his strategy.
Because of another broker and the structure of the operation I run, I have
several clients on my books that subscribe to his service. There are money
management rules to buy futures against the short naked call positions if the
market exceeds certain levels and then put a sell-stop in the market for the
futures contract. Keep putting in buy stops and sell stops as many times as
you need at the price levels recommended until the market keeps going
decisively one direction, or until you seemingly run out of money. Whichever
one comes first, of course. :-)
Anyway, I am a firm believer that there are some markets that the speculator
should just exit based on volatility. It is my opinion that some volatility
levels aren''t effectively figured into many traders' models. The current
move in natural gas is a perfect example. Double-digit percentage moves,
overnight, are not healthy for one's trading system or one's blood pressure.
Or your broker's. Or his margin clerk's. Such moves can lead to off the
chart results, good and bad.
It is everyone's dream to catch a move, such as the one in natural gas,
especially with a large position on. However, the increase in volatility can
make the market swing that way, or the other way just as easily. A $50,000
account suddenly worth $500,000 can start to have $100,000 or more moves in
day or over night. The percentage moves are out of whack, but even more so
the absolute dollars at risk are out of whack.
An industry friend of mine recently shared this thought with me; "I am making
money trading the current markets, but I have a hard time right now defining
the risks." He trades mostly futures, or so he tells me, but sometimes
dabbles in options. Of course, I have only known him to mostly want to sell
options.
The recent move in natural gas is a perfect example of a market where long
options should be used to manage risk. Recent overnight moves could have
resulted in $10,000 slippage or more per contract for a stop near the
previous close. A stop in such a market has a reasonable chance to be
entirely ineffective. Buying puts to protect off the chart profits on the
other hand gives one an insurance policy against the prospect of equally
dynamic retracements or collapses. Buying puts may seem to cost more,
because of the premium cost. However, they give you a certainty. That can
help you sleep at night. And it does not hurt the sleeping habits of your
broker and his margin clerk.
Brokers reacting to bad trading decisions of other clients can affect
sometimes you. Traders will get the discussion about trading risks that the
broker just gave to the other client, but were seemingly ignored. Now
sometimes that is good, because you get to learn from the results from other
people's trading follies. However, sometimes brokers can talk you out of
your trading plan. As a result, many times traders will just make a black or
white decision; in or out. They are stuck in certain trading strategies,
using certain tools, and can't shift gears to use other tools. For example,
some traders are biased one way or another about options trading. They are
either sellers or they are buyers. It is like a religion. Buyers won't sell
options short and sellers won't buy options to go long premium.
Situations like the Natural Gas though demand that we use all of the tools
available to us. For the futures trader with big profits, long puts give the
opportunity to stay long and participate in an extremely insane market moves,
as opposed to just regular insane market moves. :-)
For the covered call trader, buying under the market puts allows them to
reduce their risk in an expanding volatility environment. It is possible for
price and volatility to advance at the same time, so just being long futures
against short calls may not have the desired effect given the magnitude of
the market move. Capital preservation should start to take forefront in
money management moves in such situations.
My first trading experience with my own money was in the U.S. Midwest drought
of 1988. As a trading desk clerk at a discount firm, trained to trade by a
30-year veteran trader and former CBOT chairman, I opened my account and
decided to buy soybeans. Of course the market took off without me and I had
to buy them a dollar higher than when I first thought to open an account.
That was OK, because I wanted to time my entry just right and I did. I had
10 cents of bad exposure on the first contract at its worst. The market was
limit up 2 of the first 4 days I was long.
After hanging on and buying another contract well, I ultimately ended up
having a 300% move from my initial investment one day to the wrong way. I
exited all my contracts. I was up about 600% and flat. However, the market
was too big for a trader my size. I knew it and I acted and headed for the
sidelines. I had also taken advantage of my position with the firm by only
initially putting up the money I needed for margining the one contract, so I
was grossly overleveraged. Given the instant correctness of my position, I
was never required to put in additional capital.
A few days later, I knew I had made the right move. Soybeans opened $1.05
lower after it rained. Or should I say poured. I would have been wiped out
had I been in my multiple contract pyramided position. It taught me an
important lesson that this week's natural gas move reminded me of.
On a personal note, I have not been participating much on the lists I
subscribe too lately, as I have been getting my daily writing dose by putting
out a private Industry News daily e-mail. Some participants on this list are
on my list. Some of them may even be reading it. :-) Actually, I have been
very pleased with the feedback I have received from it. These are
interesting times in the futures industry and it is important for all of us
to be better informed. Those of us that remain, after the shakeout delivered
by the move to electronic and online trading, will have larger demands on us.
The move towards consolidation of the futures and securities industry
together will leave many brokers and traders in some unfamiliar markets and
regulatory waters.
Don't be surprised to see one or more of the big boys of the futures industry
scooped up by a Wall Street firm. Already First Options of Chicago has been
bought in the Speer Leads & Kellogg sale to Goldman Sachs. That was more
about the securities interests of SLK than futures though. But the world
keeps getting more and more interesting.
Regards,
John J. Lothian
Disclosure: Futures trading involves financial risk, lots of it! Past
performance is not necessarily indicative of future results. John J. Lothian
is the President of the Electronic Trading Division of The Price Futures
Group, Inc., an Introducing Broker clearing ED&F Man International, Inc.
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