Natural Gas What you are about to see in the chart below will scare the heck out of every naked option seller – and it should.
This is the type of event that is the reason we are all warned that selling a naked option has “unlimited risk.” No amount of technical analysis or hours of studying a commodity’s fundamentals can predict an event like this. Neither can logical reasons or predictions forecast similar moves in the stock markets. Monday-morning-quarterbacks are always fast to rush in and offer solutions to something that has already happened, but not one could have predicted it (nor did they).
Monday morning quarterback. noun. mainly US and Canadian informal phrase defined: a person who criticizes or suggests alternative courses of action from a position of hindsight after the event in question.
There are unsubstantiated rumors that a large West coast power company’s trading may have unintentionally been a catalyst that accelerated the extreme and unusually quick price moves in natural gas. Even if true, it’s very unlikely that such trading was anything less than fully legal and even ethical. The reason we all search for something that was done wrong, is that we wish to be assured it will never happen again; this is human nature. Human nature does not always find what it seeks, a trained mind will recognize that.
Crude Oil I held two short US$50 -strikes in JAN19 and APR19 crude oil going into an abbreviated (due to the United States Thanksgiving holiday) trading week. Even though I personally chose to ignore my own rules of exiting trades with small losses rather than allowing those losses to become larger – when I saw what happened with Natural Gas, I made a quick decision that I did not want to remain in any energy market right now. I took about a $3,100 loss on those two short options and closed them out. I’ll post those in a revised Trade Summary sheet later this week. Crude oil has fallen from $76 a barrel down to near $50 a barrel in the last six weeks (since the first week of OCT18.) Almost $8 of that drop in the last three trading days. I got burned by holding these trades. I mistakenly held to my mis-belief that crude prices would not sink to below $50 barrel. I am out of the trades now with a loss and regret my decision and disregarding even my own warning when – a week ago -I wrote on this very blog:
From Trade Commentary for 19 November 2018: “…The precipitous drop of oil prices from the $79 down to $57 a barrel has placed these PUTs in the danger zone. It is only slightly encouraging that the last few trading days have seen a slight rebound from the low of 54.90 to close just above 57.00 (basis JAN19) on Friday’s close. I already have had to exit my DEC18 55-strike CALLs because they were way too close to the money. I cannot rule out I may have to do the same with the JAN19 and/or the APR19, should crude prices not continue to rebound or at least find some support this week….” source: 19 November 2018 Trade Commentary
I finally admitted I was still playing on the train track and a train was coming! I hesitated and paid the price. I knew the risk, even wrote about it, and still stayed too long.
Here’s the April 2019 Crude Oil chart as of close Friday, November 23, 2018:
I’ve received quite a few personal emails from subscribers since the story broke about OptionSellers.com. In various ways they all asked me the unanswerable question of how such a thing can be avoided by a trader of naked options. I never use anyone’s name when quoting an email I receive. Here is a composite I made from several emails I received this past week. Please give this a read, my comments are posted below.
From a reader:I’ve done well selling options and have done this sort trading for several years now. I appreciate your letters with lots of fundamental info on commodities. I also read the optionsellers.com newsletters. The news in recent days has spooked me! It seems they did not use any stop loss. I also took some losses on natural gas calls and crude puts. I have limited my losses to between 200% and 250% of the premium (the rule of thumb “”200% rule”) Almost all my losses are always between 200% – 250% of the premium. These smaller losses are not so drastic. Now, I am wondering, is it still possible to limit my losses this way in the future? What else can be done to avoid these fast moves?
First of all, I thank everyone who emailed me. Your questions and concerns get right to the heart of the matter. You deserve a straight answer. Seeing what happened to NG prices in the early morning hours (EST) of November 14, later that day and in the next few days —- I cannot think of a single thing that could have prevented it. One solution: never sell naked options. Another solution might be to “never trade NG;” this would not prevent the same thing from happening in another market(s). A trader could use credit spreads to limit maximum losses to prevent catastrophic losses associated with unlimited risks. Doing so, would cap losses. An example of this: Instead of selling a naked CALL: sell a CALL and then BUY a higher strike CALL that results in a CREDIT SPREAD with a cap on losses. This lower risk strategy would also mean a much lower credit (a lower ROI – Return On Investment.) I will publish an article later this week featuring this strategy for both BULL credit spreads and BEAR credit spreads at my blog https://SellingCommodityOptions.com I will put the link in the newsletter and the next Trade Commentary, so you can easily find it. I do have some examples in my book: Time Farming Income Machine. I’ll have the article up in a day or two on the free blog, so just wait for that.
I have also had some readers write me and ask, “Why won’t my broker let me trade naked options in my IRA (or other tax deferred account)?” The NG fiasco allows me to easily answer that question: Because you can lose it all and still owe more money in addition to what you lost. A few brokers still allow it, so long as a trader can afford to agree to it (and perhaps proof of a high net worth that could fund such a loss.) Other brokers will not allow naked options but will allow option trading -including credit spreads with limited risks and of course, covered options such as covered-calls and cash-secured puts.
Another email I received asked me this question: “Won’t the 200% Rule protect me from what happened with NG?” The answer is: No. In this NG event, the market moved so fast, there were no traders to take the other side to close the losing trades out. This is sometimes called “a squeeze.” It was also not possible to buy or sell other options and/or futures combinations to prevent further losses during this event. It is a common belief among inexperienced traders that so-called experts or advanced option traders can always “find a way out” with one or more sophisticated techniques. This just simply isn’t true. One can almost always add or roll positions to modify a trade (but not usually in a fast market) and even then – it often requires taking on MORE risk without any guarantee of a price turnaround (aka: good money after bad.)
In most instances, the 200% Rule is a good guideline. Let me give you an example of when it probably isn’t: One very astute reader, an experienced trader, sent me this comment: “I sold a gold 1600-strike CALL at 0.40. This 0.40 went up to 0.90. According to the “200% rule” I should get out, but gold is still only $1224 an ounce, still FAR BELOW the 1600-strike. I don’t see that this makes sense for me to exit this trade, as I can easily tolerate some drawdown with the options still so far OTM.”
My answer to him: I agree. This is an example when a well-meaning rule just is not necessarily going to work very well. Then, I added: The 200% Rule is a guideline. It is, in my opinion, a point to raise a ‘red flag warning’ but as you pointed out, it doesn’t always overrule common sense and one’s knowledge of a commodity’s price action and fundamentals.
Another reader sent me more or less the same comment and he suggested, “Maybe it should be changed to the “300% Rule.” I answered back to him that I would give this some thought. When the 200% Rule only involves an increase in an already small ($40 to $100) premium, perhaps one should give it further thought. However if a $400 premium goes to $800, I am inclined to invoke the 200% Rule.
Please always remember, this newsletter is a TRAINING BULLETIN and not a trade advisory service. I cannot and do not have your personal information, the size of your account, your net worth, your risk tolerance, or have any full knowledge of your experience in trading. Therefore, it is not proper for me to assign any trades and designate whether they might be appropriate or inappropriate for you personally. Also I never can know how many markets you are trading, what quantity of strikes, the exact strike values, or where you entered a trade; all more reasons that I do not give specific trading recommendations to an individual. You and only you are responsible for your trading decisions. I welcome any and all questions and I’m glad to answer/discuss them. This is how we learn. Thank you for your email. I am not a trade advisor, nor am I a broker, nor do I sell independent courses or software. I have this newsletter and I publish a few personal finance trading books. And I do not manage any money for other people, nor do I want to do so. I am first to admit this type of trading is not for everyone. I’ve done it for over 25 years, I will continue to use it, and always enjoy sharing what I know to help others learn about this trading.
I continue to believe that, when done responsibly, this investment method is a very viable way of earning income by selling far OTM options. There are almost always ways to help control risk exposure, but there is never a way to eliminate all the risks involved in this (or any other) type of trading.
Since I’ve taken up all of today’s commentary with basically one subject, I may issue another commentary later this week. If I do, I will (as always) send you email notification of a new post and/or trades. I always welcome your comments and observations; my email remains: Don@WriteThisDown.com Thank you and have a great week. – Don
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