Commodity Option Sellers Face Optimal Win/Loss Ratios but That Doesn't Guarantee Success
Because more options than not expire worthless, commodity option sellers often have much better win/loss ratios than futures traders. However, the drawback of an option selling strategy is the reality of accepting theoretically unlimited risk in exchange for limited profit potential. In the game of commodity option selling, winning far more trades than you lose is only the beginning. An option seller must be savvy enough to prevent the small percentage of losing trades from wiping out months of profit. My intention isn't to deter you from selling options, in fact this is the strategy that I prefer and recommend as a commodity broker to my clients. However, those that partake in this practice must be ready and willing to face the consequences during draw-downs.
U.S. futures exchanges don’t accept stop loss orders on options. Even if they did, it wouldn’t be in the best interest of traders. This is because it wouldn’t be feasible to place stop orders on most options, or option spreads, due to the nature of the bid/ask spread and the seemingly high probability of being stopped out prematurely. Remember, a stop order becomes a market order as soon as the named stop price becomes part of the bid/ask spread. If the bid/ask spread is wide due to a lack of liquidity, a stop order will be triggered and filled at a dramatically inopportune time and price (unfavorable slippage).
Instead of placing stop loss orders, short options should be monitored closely; keeping a "mental" stop in mind is important. I typically advise traders to use a double out rule. This means for every naked short option, whether it is within an option spread strategy or sold individually, you should strongly consider buying it back at a loss if its value doubles from your entry point. In essence, if you sell a crude oil option for .50 cents or $500 ($10 x 50) and following your entry the option doubles in value (appreciates to $1.00 or $1,000) it may be fair to say that you were wrong. At this point, a trader should strongly consider liquidating the position and moving to the next opportunity. Failure to do so may convert a moderate loss into something much more.
Unfortunately, in fast moving markets the value of an option sometimes explodes in value very quickly, making the double-out rule impossible to implement. Even so, the double out rule should be part of the overall trading plan. This doesn't necessarily mean it is an exact science; trading is an art and should be treated as such. Imagine being short a put option in a declining market that has reached the designated double out point, but the market is approaching significant support. If you strongly believe that the futures price will hold support, exiting your position at top dollar in panic, doesn't make sense. However, on the flip side; if you find yourself counting on hope rather than rational logic, you have let it go too far. Sometimes the line is difficult to see until it has already been crossed but its times like this that make or break a trader. I believe the ability to properly manage these scenarios come from instinct and experience; it cannot be attained from reading a book or attending a seminar.