I have been keeping something from you for 6 months.
I like to share openly with BFP readers but I decided not to disclose this until I am ready. Don’t get me wrong. This is to ensure your safety because it is a risky endeavor that I do not want to entice you into doing it.
The truth is – I have been selling naked options for income. Selling naked options means I am betting the options price will go down and I do not own the underlying assets. There are a few factors that affect options price such as the underlying asset’s price, volatility and time decay.
Statistics show that most options expire worthless by their expiry dates. That is why selling options has high probability of winning.
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But high probability of winning alone does not mean it is profitable. It is about having a positive expectancy and this includes the average winning and losing size on top of the probability of wins. You can read more about it here and here.
Options is one of the most complex and least understood asset class in the financial markets. The most popular figure of anti-options-selling got to be Nassim Taleb. I have great respect for him and he said that options are often mis-priced due to miscalculation of the tail risks by the conventional options pricing theories.
In fact, he said it was impossible to price the tails because nobody can predict the future, and nobody can accurately calculate the probability of an unexpected event. As such, he likes to buy far out-of-the-money options. He is betting for rare but impactful events to happen. In fact, he thinks it is not as rare as what people think it is.
Jon is the biggest Taleb fan I know. He doesn’t believe in options selling totally. I told him I am going ahead to sell options even if he disagrees. I am going to do it even though I agree with what Taleb said. I explained to Jon that all forms of trading and investing are all about risk management.
Yes, options payoff are non-linear which is unlike traditional linear payoffs from long-short equity strategies. However, it does not mean you will not blow up your capital if you long or short shares. Every trader and investor needs to practise risk management because there is one trade out there that will wipe you out, regardless if you have total conviction about being right.
So what is the difference between selling options or any other strategies? I see one similarity rather than differences – all are risky. I agree with Jon I am picking pennies in front of the steamroller. But this is similar to scalpers, swing traders and trend followers. I will try to jump away from the steamroller as fast as I can so that I can continue to pick the pennies. Jon questioned my overconfidence in jumping off in time and I admit I stand a chance to blow up, without a doubt. And if I do, I hope he will pick me up from there. 🙂
I learned options selling from Dave Foo – whom I interviewed on Secrets of Singapore Trading Gurus (do not bother searching for his video, we did not film it). He has been selling options for many years and he was able to get 5% returns per month. I thought his method was simple to implement but I was surprised to hear that he asked the class not to put too much capital for a start so that we can make all the mistakes at minimal costs. He also said to give myself six months to get familiar with options selling.
I started with US$20k as my initial capital and I increased the capital to US$40k and eventually US$50k within these 6 months. How did I performed? If I tell you I only have winning trades and a happy life ever after, I must be kidding you. Likewise, if anyone tell you it is all profits, he must be kidding you big time. Dave was right, I did make mistakes and I realised how costly it is. Let’s look at the performance and I will go through the mistake in detail.
- Jan 13: +US$708.75
- Feb 13: +US$883.12
- Mar 13: -US$567.51
- Apr 13: -US$9,072.49
- May 13: -US$890.02
- Jun 13: +US$1,333.13
Apr 13 was a BIG OUCH! I had a 25% drawdown on my capital. This was where I truly understand Dave’s words about starting with a small capital and make the mistakes in the first 6 months. In Apr 13 alone, I made all the mistakes I could. First, I miscalculated the strike price and got in a trade that I should not have taken. That cost me a US$2k loss. Second, I did not manage to cover the loss for the gold trade because I was away in Taiwan.
By the time I checked my positions, I was down US$5k. It was just past US trading and the market liquidity was thin. The price spread was wide and I was not able to get a good price to fill. But I could not wait until the liquidity come back as I might not have any internet connection to check and I do not want to worry about the position during the trip.
Hence, I cut loss and covered the position at a bad price. I should not be so complacent that I can afford not to monitor my positions closely. I deserve the loss totally and there is no excuse about that. The market is cruel when you are careless.
The Apr trades also taught me the importance of capital preservation. Losing US$9k meant I need many months of profits to get back even. This one month alone is good enough to warn me the chance of blowing up if I do not manage the risk properly. It humbled me. In the middle of May, I tighten the risk management rules.
Instead of rolling trades like what Dave suggests, I prefer to cut the loss fast. And instead of taking a risk-reward ratio of 3:1, I have reduced the risk-reward ratio to 1:0.7. I had 3 losses in Jun alone and I managed to contain them, below US$800 for each loss, and edge out a profit of US$1.3k for the month.
My purpose of telling you all these is because I want to show you the reality of trading and to convince you how hard it is. A lot of people are lying to you how much money you can make from trading. I want to tell you the truth. I want to show you my struggle. I don’t care if people would laugh at me and my losses.
I will continue to trade and stick to the risk management closely. I will let you know the results in later part of the year. If such big losses happened again even though risk management is followed properly, that means this strategy has no positive expectancy.