[Here’s a guest post from a great system developer, honest guy, and my friend Kevin Davey. He beat me to the punch with an article on option selling/writing premium. Tom and I periodically revisit this concept to see if we are missing some way to package selling premium in a way that makes sense for clients, and we keep coming up with a resounding NO–the dangers are not manageable (except at the expense of most of your profits) and are not justified by the returns. Just a few months ago we tore into some “strategies” by a very well-known and well-respected options teacher, and came away scratching our heads at the well-respected part: writing open-ended risk and buying a deep ITM call (I guess because stocks tend to go up?) is… well… stupid, in the long run. Here’s Kevin, with three solid lessons from the recent debacle in natty:)
Last week a decent size Commodity Trading Advisor/Pool blew up. I don’t know the exact amount involved, but the CTA claimed to have around 300 accounts, and the minimum to open an account was $500K. So, there could be around $150 million involved.
And that $150 million is gone. In fact, more money than that is gone, since many accounts were left with debit balances (meaning, you as the account holder need to send the broker a check just to close your account!).
The CTA involved ran a strategy based on futures option selling, primarily naked option selling. The operator had been running that strategy for years, and in fact had written a well received book on the subject. He was basically profiting from selling premium.
Some people view selling premium as a more conservative trading approach. Month after month, as options grow closer to expiration, the option seller makes a little bit of money, which adds up over time. Unless of course there is a big adverse move. Then the option seller can lose a lot of money quickly.
This type of strategy is akin to picking up pennies in front of a steamroller. It works great, until the day when you trip, and end up getting smooshed. The end result taunting steamrollers, and selling naked options, is typically not pretty.
A 90% or even 99% winning percentage might not be enough to save such an approach, if the 1% of losers are massive.
So here we a market professional, with many years of trading experience, losing the steamroller battle. What can the rest of us learn from this? Here are 3 lessons:
Don’t Ever Think Trading Is Easy
With most activities, it gets easier the more you do it. Think of the first time you drove a car. It was scary – lots of other cars to deal with, confusing traffic rules and of course distinguishing between the gas pedal and the brake – a lot to mentally process! But with some practice, it became manageable. After a while, it became almost automatic.
Some people think trading should be the same way. Unfortunately, while some aspects of trading get easier, overall trading is a difficult endeavor, regardless of the amount of experience you have. The aforementioned advisor had decades of experience, and still got crushed. So much for easy money via trading.
Don’t Be Greedy
They say if you put a frog in a pot of cold water, and slowly raise the temperature, eventually you can boil the frog, and he will not even try to escape. I don’t know if that is true or not – and frankly I don’t want to kill a poor frog to find out – but I do know that risk sort of feels like boiling a frog. The first time you put on a position with say $1,000 risk, it is scary. But, after you do it 100, 1,000 or 10,000 times, you become accustomed to it. And maybe you start to think “hey I can risk more than $1,000.” And so begins the steady climb in your risk comfort level. Usually it is accompanied by an increase in your profit expectations.
Now, I have no idea what the risk limits were at the steamrolled fund, and I have no idea if over time their risk controls became complacent or expanded. But I do know that increasing one’s risk, or feeling more and more comfortable with risk, is easy to do, especially if you are searching for higher and higher returns (aren’t we all?).
So, if you find yourself scrambling for more profits from the markets, remember not to enlarge your risk profile to get those profits. You might just be setting yourself up for ultimate failure instead.
Don’t Forget The Market Is The Boss – Always
I remember fishing down in Florida years ago with my dad. As we were casting out from a pier, a salty fisherman came up to us and warned “just remember, the pelican is boss here. He will snatch the bait right out of the air as you are casting. Then he’ll get all tangled in your fishing line. He preys on the unwary.”
Some people, after a history of success in a given field, tend to become unwary. I’ve seen many traders who thought they were veritable gods, and yet eventually the market humbled them and brought them back down to earth. That is important to remember: the market, not you, is the ultimate boss. Just as the market gives profit, it can just as ruthlessly take away profit.
Never forget: The market is the boss.
Last week’s disaster for one fund is a great lesson and reminder for the rest of us. Trading is hard, and we always have to be on guard. Trading disasters can happen to any of us.
The old fisherman I mentioned earlier? My dad and I walked by him as we left the pier. He was trying to untangle his fishing line, which was wrapped all around a pelican.
About the Author
Kevin J. Davey is a full-time professional trader and a top performing systems developer. Kevin is the author of the best-selling trading book “Building Algorithmic Trading Systems: A Trader’s Journey From Data Mining to Monte Carlo Simulation to Live Trading” (Wiley Trading, 2014.) and recently authored “An Introduction To Algo Trading” (Amazon, 2018). He generated triple digit annual returns of 148 percent, 107 percent, and 112 percent in three consecutive World Cup of Futures Trading Championships® using algorithmic trading systems.
His web site, www.kjtradingsystems.com
Active in social media, Kevin has over 14,000 Twitter followers. An aerospace engineer and MBA by background, he has been an independent trader for over 25 years. Kevin continues to trade full-time and develop algorithmic trading strategies.