Premium Collection; AKA Short Option Trading
There are advantages and disadvantages to every commodity trading strategy, but in my opinion, option selling delivers the best overall odds of trading success.
The favorable probabilities are due to the simple fact that options are priced to lose, and time is on the side of the option seller. To illustrate, an option buyer must see the market move in the desired direction, in a minimum magnitude, in a finite time frame, in order to see a profit. Option sellers, however, have far more room for error and can even make money when moderately wrong in regard to futures market direction. With that said, there is no such thing as "easy money" in the commodity markets. Successful commodity option premium collection requires proper risk management, keen instinct, patience and even a little bit of luck.
*There is unlimited risk in commodity option selling!
Five Talking Points for Beginning Option on Futures Sellers
1. As a futures option seller, it takes money to make money...leave plenty of excess margin in your commodity trading account
Short option traders must be properly funded to be capable of riding out any storm that might materialize. During times of excessive commodity market volatility, many traders turn to the limited risk of option buying. This has a tendency to artificially inflate commodity option prices, due to the increase in demand for the securities. Also, in a more volatile market environment, commodity traders often believe it is more likely that a long option strategy will have an opportunity to pay off. I argue this is a false perception because options on futures buyers must overcome their cost of entry before turning a profit; the higher the price of the option on the way in, the bigger the obstacle to being profitable will be. Nevertheless, in all of the excitement traders often behave emotionally rather than logically; as a result, they exuberantly bid up the prices of low probability options to shocking levels.
Short-Option position sizing
In most options and futures markets, you would want about $10,000 in a trading
account for one, or two, commodity options sold. In some of the higher margined markets such as gold, it would likely be in your best interest to have much more. Another way to determine the appropriate account and position size is excess margin. Generally speaking, it is a good idea to utilize 50% of less of your account when trading short options. Simply put, if your account size is $10,000 you should aim for trades that will require a margin of $3,000 to $5,000. On the flip side, the excess margin listed on the bottom of your statement should be between $7,000 and $5,000.
Some might look at the funds not being used toward margin as a missed opportunity, or a waste of risk capital. However, nothing could be further from the truth. Undercapitalized commodity option sellers will almost undoubtedly get into trouble. Without plenty of excess margin in a commodity trading account, it can be difficult to survive the normal ebb and flow of the futures markets. In addition, a lack of capital dramatically increases the odds of a margin call, which can result in pre-mature liquidation of an option trade. If the situation is dire enough, the liquidation might be at the hand of your commodity broker; which is an unpleasant experience for all parties. With that said, not all commodity option brokers are created equal (see the next talking point).
2. The commodity broker you choose for your option selling account DOES matter!
Unfortunately, many beginning option sellers overlook the impact their choice of commodity broker has on the bottom line of a trading account. Even worse, they assume the only affect their option broker will have on their trading results is the per contract commission charge. As a long-time futures broker I can assure you, there is much more to the relationship between a trader and his commodity brokerage than transaction costs.
Regardless of whether a commodity option trader is placing orders online though a futures trading platform, or by phone or email with a broker, the choice of a brokerage firm will eventually play a big part in the success or failure of a commodity option trading strategy. This is because many futures brokers are averse to allowing their clients sell options on futures; even those brokers that allow it often take other actions to reduce risk exposure to the brokerage such as restricting the commodity option contracts available to trade, increasing short option margin requirements (above and beyond the exchange minimum SPAN margin), and even force liquidating client positions at the first sign of trouble. Futures brokers with heavy handed risk managers can wreak havoc on an option selling account. Imagine your option broker liquidating your trades at a highly inopportune time, before a margin call is triggered, and without notifying you. Such an event can be a costly and frustrating experience; but it can also be avoided by ensuring your commodity option broker is willing and capable of servicing your account type.
My commodity brokerage service, DeCarley Trading, specializes in handling option selling accounts.
3. Most futures and options traders lose money!
Whether trading futures or options, a common mistake commodity traders make is to blindly follow the lead of random trading books, business news stations, popular financial newspapers, and magazines. The ugly truth is most commodity traders lose money. Knowing this, why in the world would you want to do what "everyone else" is doing? In light of the success rate of the masses, you probably don’t want to join them. Most traders are buying options, and or employing futures trading strategies; a much smaller percentage of traders are selling commodity options. Perhaps option selling is the prime “contrarian” strategy, and should be considered by all market participants for the simple reason that it is unpopular…and historically speaking, unpopular ideas in trading sometimes turn out to be the gems.
4. Sell Commodity Options on the contrary
As opposed to simple premium collection without a purpose, such as carelessly selling calls and hoping nothing happens, I feel like the best odds of success is to patiently wait for market panic or excitement of the masses and to play the other side of the trade. Warren Buffet said it simply, "Be fearful when others are greedy, and greedy when others are fearful"; he wasn’t referring to option trading but the concept can certainly be applied. For instance, some of the best option selling opportunities occur following massive price spikes in a particular direction. When such a price extension occurs most speculators are busy buying options in the direction of the trend at obscenely high prices, when the best trade is often to be a seller of those over-priced options. Of course, this type of approach is equivalent to catching the proverbial “falling knife”. If what you believe to be the exhaustion of a trend, turns out to be the early stages of a much larger move the trade could be in danger of substantial losses.
Selling options as a contrarian isn't easy money, but I do believe it might be advantageous from an odds perspective. After all, times of directional volatility and emotion often involve excessive option premium and this makes it a great time to be an options on futures seller. If you were a store owner, you would prefer to sell hot products at high prices, as opposed to items on the discount rack. Option selling is no different.
Of course, the trick is to be patient enough to improve the probability of your entry being at the peak of volatility; this is easier said than done. However, completely disregarding commodity market volatility when implementing a short option strategy could lead to painfully large losses regardless of whether the futures price ever touches the strike price of the short option.
5. Who are candidates to sell commodity options?
Before choosing to implement an option selling strategy in the futures markets, you must first honestly assess your ability to accept the prospects of unlimited risk and margin calls. Not everyone is capable of managing the emotions that come with these two characteristics of the strategy; and even those who are, will have moments of weakness. As a seasoned commodity option broker, I can attest the markets are capable of making a grown man cry. Failure to keep trading emotions in check could mean letting losers get out of hand, or panicked liquidation at unfortunate prices. Either scenario could be psychologically and financially devastating to an option selling strategy.
Sell Options on Futures for a Higher Probability Trading Strategy
Introduction to Commodity Option Selling
The premise of commodity option selling is to collect premium through the sale of options on futures in hopes that the time erosion and volatility decay of a particular short option will overcome any increase in option value due to adverse price movement in the underlying futures market. An option selling strategy offers unlimited risk and limited reward, which is opposite of what many might consider rational. Nonetheless, the odds of success on any given short option trade are arguably in favor of the seller over the buyer.
The concept of an option is nearly identical to that of an insurance policy. The buyer purchased the instrument to receive a payout should a substantial event occur. The seller of the instrument, is collecting a payment in hopes of the “policy” expiring worthless. Accordingly, the practice of commodity option selling is similar to the business of selling insurance policies.
Most of the time, premium is collected by the insurance company and kept as a profit, but there will be times in which unexpected circumstances arise and trigger "claims" against the policy, or in the case of option trading a large drawdown at the hands of an increasing option value. In other words, like that of insurance policies, the odds of success on each individual option selling venture is high, but the challenge is to keep the magnitude of the losing option selling positions to a level in which it is possible to be profitable in the long run.
Types of short options on futures
Short Call – Bearish Option Strategy
Call option “writers” receive income (option premium) in return for the liability of honoring the option buyer’s right to buy the futures contract at the strike price. A short call is an eroding asset to the buyer and an eroding liability to the seller.
The buyer has the right, but not the obligation to take delivery of the underlying futures contract at the stated strike price but the seller is obligated to accept the assignment of a short futures contract at the strike if the option is exercised. The seller's risk of being forced to honor the buyer’s rights diminishes with time; all else being equal the value of the option will erode.
In a nutshell, the seller of a call option keeps the premium collect if the trade is held to expiration and the futures price at that time is below the strike price of the call option.
Short Put – Bullish Option Strategy
Put “writers” receive income (option premium) in return for the liability of honoring the option buyer’s right to sell the futures contract at the strike price. If exercised, the option buyer has opted to exercise the right to go short a futures contract at the strike price and the put seller is obligated to buy the futures at the same price. Identical to a short call, a short put is an eroding asset to the buyer and an eroding liability to the seller. Also, the seller's risk of being forced to honor the buyer's rights diminishes with time and volatility.
To summarize, if held to expiration, the seller of a put option keeps the entire premium collected if the futures market is trading above the strike price of the put. We’ll go over an example of a short put to give you a clearer picture of how a short option trade works.
Short Strangle – Neutral Option Strategy
Some option sellers practice what is known as a delta neutral strategy in which both call options and put options are sold simultaneously to create a trade without any directional bias. In its simplest form, a short commodity option strangle seller sells a call for every put sold; generally the strike prices are equidistant to the current futures price.
The advantage of selling an options strangle in the futures market, as opposed to selling only one side of the trade (a call or a put), is increased profit potential and more room for error. Obviously, by selling both a call and a put, the trader has automatically doubled the potential gain on the trade. Further, the sale of both calls and puts along with the additional premium collected, provides a bigger buffer to cushion losses should the futures price trade beyond the strike price of either commodity option. Accordingly, many believe this to be a lower risk strategy relative to selling calls or puts outright on a directional basis.
Selling a Commodity Put Example (Crude Oil)
In the example portrayed in the displayed chart, it might have been possible to sell a September $62 crude oil put for 53 cents, or $530, at a time in which crude oil was valued near $80. The same option was worth only 17 cents ($170) just two days earlier prior to a multi-day plunge. Options that have tripled in value, as such, often have a tendency to see sharp premium erosion should the futures market stabilize. Accordingly, these types of spikes in option premium are attractive to option sellers.
On the contrary, those that were already the 62 put prior to the two-day sell-off would be an unpleasant situation. This just goes to show you how important timing and volatility can be, even in a so-called passive strategy such as option selling. Simply put, making money by selling commodity options isn’t as easy as selling calls or puts and hoping for the best. Traders must be patient in order to be in a position to capitalize on an increase in volatility, as opposed to getting run over by it.
The maximum profit of this particular short option trading example, is $530 minus transaction cost. The max payout occurs if the option is held to expiration and the futures price is above the strike price of $64. However, even if the price is a little below $64, all is not lost; this short option position pays off at expiration with the price of crude anywhere above $63.47. This is because the premium collected of 53 cents, or $530, acts as a buffer to the risk of being assigned a futures contract at the strike price of $64.
Should the price of crude be trading below $64 at expiration, the risk is similar to that of being long a futures contract. The option value will fluctuate quickly and the trade faces theoretically unlimited risk.
As you can see from the chart , it is possible for this trader to be profitable whether the market goes up, down, or sideways; the only risk is in a massive price collapse (in this case below $64). If the price of crude is above $64 at expiration ($64 to infinity), the max payout is received by the option seller. In other words, the profit zone is large and likely, while the loss zone is far less likely to be seen.
The Key to Option Selling is Premium Erosion
Similar to buying a car and watching its value drop as you drive it off the lot, (all else being equal) options on futures lose value with every minute that passes. This is because as time passes, the odds of an extreme event diminish. Assuming the futures price doesn’t increase in volatility, and more importantly do so in an adverse direction of the short option, time is money to an option seller. On the other hand, option buyers often suffer slow and painful losses in the absence of a dramatic price change. In fact, some studies have suggested that somewhere between 70% to 90% of all futures options expire worthless.
Because of these characteristics, option selling is the only strategy in which a trader can be wrong and still make money! For example, a trader going short a call option is accepting the risk of the futures price going above the strike price of the short call. However, the futures price can go up, down, or sideways and still produce a profit to the option seller as long as the futures price doesn’t exceed the strike price of the commodity option.
The most common turn-offs to options on futures selling are fears of margin calls, stories of account threatening losses but the truth is trading of any futures or options strategy involves substantial risk. At least commodity option sellers are putting the odds in their favor. On the contrary, option buyers are in essence purchasing lottery tickets in which their risk is limited, but the odds of success are unattractive. In other words, although option buyers face limited price risk, they are more likely to incur a high percentage of losing trades.
The bottom line on option selling strategies
Selling options can be a high probability trading strategy, but it doesn't come without stress and risk. Although option sellers are betting against extreme price moves, it is critical that traders attempt to time their entry in regard to market analysis, sentiment and, most importantly volatility. Failure to do this will increase the odds of panicked premature liquidation, large draw-downs, or worse. Be selective and remember, it is better to miss a trade than to impatiently enter a market only to suffer the consequences of exploding market volatility, and therefore option values.