Ask a Broker

ISSUE 401 | JAN 2005

Q: I am interested in selling options to collect premium, as I understand that most options expire worthless. What are the major risks in doing this and are there strategies that contain more/less risk? -Curious

A: It is true that 80 - 90 percent of options expire worthless, but selling options is risky business. It is important to understand that selling an option has margin requirements (unlike buying an option where what you spend is what you risk) and that they will fluctuate during the term of the trade. One of the primary risks with shorting options is that the underlying market will finish in the money for the respective strike you are short. If this happens, you will be assigned the corresponding number of underlying contracts, which will be a losing position. The following example illustrates this theory:

• You are bearish the euro currency, currently trading at 13450 (as of January 14).
• You decide to sell one 13500 call with two weeks left until expiration.
• On the day of expiration, the market closes at 13550.
• You will be assigned the call and become short one euro future from 13500.
• At this point, you are down 50 points ($625)--less the premium received for selling the option--and have incurred an initial margin requirement of $3,000.

Keep in mind that this scenario has several “outs,” as short options can be purchased back for a profit/loss in order to minimize this type of risk exposure. However, if you are not concerned about being short from the level of your strike and have the required equity to ride out such an outcome, then this trade will appear slightly more appetizing. Selling options is a capital-intensive strategy that requires a watchful eye, especially in volatile markets. It differs greatly from the more common strategy of buying options or option spreads to capture directional market moves, and waiting for expiration or profit. Selling premium is not as easy as it appears. Although it is a play that exhibits a good success rate, the failures can be dramatic if not managed properly. There are a number of risks involved with options strategies—you may not be able to get out of the trade until expiration, and you can face potentially large losses if the underlying futures contract makes a sizeable move. There are numerous designs for this style of trading, so for more information, please contact a Lind Plus Market Strategist. Call 800-571-1122 or email lindplus@lind-waldock.com.

Kristina Zurla Landgraf is editor of Lind eWire. She can be reached by email at editor@lind-waldock.com. To submit a question for Ask a Broker, contact the editor at that address. We welcome your comments.

Futures trading involves substantial risk of loss and is not suitable for all investors. Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades, and any dollar amount quoted is exclusive of commissions and fees. All trading decisions will be made by the account holder.

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