Why do some brokers discourage or forbid short option trading?
Selling naked options leaves traders exposed to theoretically unlimited risk, while accepting the potential of a limited reward. In other words, it is the exact opposite payout diagram an option buyer faces (which is limited risk but unlimited profit potential). To the green trader, the prospects of being an option buyer is habitually more appealing. After all, who wouldn’t want the possibility of windfall profits with a finite risk? Notwithstanding the appeal, option buyers face a dismal likelihood of success. In other words, if the probability of bonanza style profits are slim then perhaps option buying is nothing more than the equivalent to buying a lottery ticket. The risk of loss is limited and maybe even small, but the odds of a return on the investment are also trivial.
The concern that most brokerage firms have with option sellers, isn’t that traders face unlimited risk. If that was the issue, they wouldn’t allow futures trading either (futures traders also face theoretically unlimited risk). The primary apprehension brokers have with short option trading is option market liquidity during highly volatile market conditions. The option market is not nearly as liquid as the underlying futures market, because of this it can sometimes be difficult to accurately value positions and account balances of option trading clients.
In other words, if a brokerage firm has a client trading futures in danger of losing more money than is on deposit in their trading account, the risk managers can easily assess the situation to determine if forced liquidation of positions is necessary. This is because they can see the exact price of the futures contracts and conclude the client’s account balance quickly and precisely. Ideally, any necessary forced liquidation would occur before the account balance falls into negative territory, but that isn’t a guarantee.
In a similar scenario with an option selling client, the risk manager might not have access to reasonable valuation or pricing. Not only does the lack of clear position valuation pose risk to the client and broker, it also requires more brokerage firm manpower and experience to manage the risk than futures trading account would. We saw an extreme case of this during the August 2015 downturn in the e-mini S&P 500 futures options (ES). Toward the end of a precipitous four-day decline, the bid/ask spread in most of the ES options was 10.00 points, or $500, in contrast to .50 in normal market conditions. In addition, option prices were increasing exponentially without reasonable limits. Those clients trading short options in high quantities could have easily seen tens of thousands of dollars vanish in an instant. Because the possibility of the spreads and option premiums “blowing up”, as it did in this scenario, housing short option trading clients requires far more brokerage firm risk management resources. As a result, traders should expect to pay more in commission for their option trades than they do futures trades.
Also complicating the issue, but for good reason, commodity exchanges don’t accept stop loss orders on options as they do futures. Thus, pre-emptive risk management isn’t a possibility. Stop orders are not possible on options because they are subject to widening bid/ask spreads, which in turn can trigger a stop loss order prematurely (stop orders are elected as soon as the market price reaches either the bid or the ask); it isn’t necessary for a trader to actually take place at the stop price to elect the order.
Deep discount commodity brokers cannot afford to let clients sell options freely because their profit margin is so tight. At a potential gross profit of pennies per trade, the extra work and potential debit account risk of allowing clients to sell options doesn’t make sense for their business model. Thus, if you are trading with a discount broker that is letting you sell options, you had better be aware of the fact that your positions are prone to heavy handed forced liquidation at the first sign of trouble. This is a massive disadvantage to an option seller; in my opinion it reduces the strategy to a sure fire way to lose money. Accordingly, be aware of your broker’s policy and “friendliness” to option selling before getting started.