This is why selling volatility can be dangerous

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This post is for education purposes only and should not be interpreted as a trade recommendation. Options trading may not be suitable for all investors.

February’s market crash taught the dangers of selling volatility. Yesterday there was another example in the options market.

The company was L Brands (LB), parent of Victoria’ Secret and Bath & Body Works. The strategy was naked short puts… which can be wonderful when stocks move sideways or higher. But when they fall, things aren’t so pretty.

In LB, things didn’t look so pretty.

A trader bought 18,000 April 37.50 puts for $1.50 and sold an equal number of May 35s for $1.25. Volume was below open interest in the 37.50s, so it looks like they rolled down the lower strike after closing an existing short position… and apparently losing a money in the process.

Here’s what probably happened: Put sellers agree to buy a stock if it falls to a certain level over a certain period of time. They essentially back-stop other investors and, in the process, get paid. As long as the stock remains over the price in question they make money. (See our Knowledge Center for more.)

This time it didn’t work because LB’s level line in the sand was $37.50. Once the ailing retailer fell below that level, the trader faced the risk of being assigned shares on or before the April 20 expiration date. So they paid money to close the position and sold more puts down at the 35 strike, this time one month later.

Making the adjustment cost a net $0.25 per share, or $450,000 in total. (Remember every option contract controls 100 shares.) It also exposes them to four more weeks of potentially sleepless nights in a company that’s already the worst performing member of the S&P 500. Analysts blame the weakness on slowing mall traffic retail and market shift away from expensive lingerie. Then you also have a big slug of debt on its balance sheet.

LB ended the session down 3.01 percent to $37.06, and has lost 38 percent of its value since the start of January. Overall option volume was more than quadruple average amounts over the last month, with puts outnumbering calls by a bearish 32-to-1 ratio.

This post is for education purposes only and should not be interpreted as a trade recommendation. Options trading may not be suitable for all investors.

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David Russell is VP of Content Strategy at TradeStation. Drawing on nearly two decades of experience as a financial journalist and analyst, his background includes equities, emerging markets, fixed-income and derivatives. He previously worked at Bloomberg News, CNBC and E*TRADE Financial. Russell systematically reviews countless global financial headlines and indicators in search of broad tradable trends that present opportunities repeatedly over time. Customers can expect him to keep them appraised of sector leadership, relative strength and the big stories – especially those overlooked by other commentators. He’s also a big fan of generating leverage with options to limit capital at risk.