Avoid Rookie Mistakes in Options

Traders new to option selling often don't fully understand the magnitude of their trades. Covered calls are easy. Selling naked puts requires greater cognizance of the value of the underlying position you are committing to.

It is tempting to simply look at the premium received on well out-of-the-money (OTM) puts, thinking the risk of their eventual exercise is quite remote. An example will help illustrate my point.

Teen retailer Abercrombie & Fitch (ANF) is way down in price and close to solid technical support. The shares were at $35.96 recently, down from a yearly peak of $55.23. Contrarians like the fact that the industry group is universally despised. This is where ANF trades when nobody is willing to recommend it. That was also the case in the summers of 2010 & 2012 before it rebounded sharply.

 The recent decline led to juicy options premiums on the Jan. 2015 puts. On August 28, the $20 strike put was trading for above $1 per share.

 Selling six contracts would bring in about $630 in premium. That seemed extremely tempting on a strike that was almost $16 per share below an already beaten-up quote. Keep in mind, however, the unlikely -- but conceivable ¿ worst- case scenario in which ANF drops badly to below $20.

Those six puts would require an $11,370 potential net cash outlay. That amount of money was at risk in search of an easy $630 gain upon expiration. The way OTM puts represented a high winning probability, but low potential reward situation based on the money tied up.

A good alternative put sale was available with a much lower 'penalty' if an unexpected huge drop were to occur. ANF had spent almost no time below $30 since 2009. Selling just one contract of the Jan. 2015 $35 put would have brought in the same $630 in premium that six $20 puts did.

If Abercrombie simply remains above $35 on expiration date, the option seller will keep the same $630 net profit. The big difference in risk is the option writer's worst case exposure.

The single $35 put would only commit the put seller to owning 100 shares at a net $28.70 per share. If ANF collapses, the worst-case outlay would be just $2,870 (net) rather than over $11,000.

Using the super-conservative strike price traded a big OTM distance for a large dollar exposure. There is no 'free lunch'.

You should not have been writing on ANF if you didn't think the shares would do OK. If they do go up, that extra cushion will be unnecessary. If you are wrong, it is much better to have just a fraction of the dollar commitment.

Selling big numbers of contracts to generate modest income is not usually a great way to go. It requires a large portfolio value to properly diversify. Novice option writers are advised to start with smaller contract quantities that are closer to the money.

You will sleep better and likely end up making the same profits.

At the time of publication, Price was short ANF Jan. 2015 $30 and $35 puts.