Why Sell Options

You vs. The Professionals

If you have ever felt like professional traders and fund managers had an edge over individual investors, you were right. If you have ever thought that there were strategies to help you level the playing field with these traders, you are right again.

If you have ever felt like professional traders and fund managers had an edge over individual investors, you were right.

Many investors are now seeking to gain exposure to the commodities markets and the diversification and leverage they can offer. However, for many, trading futures contracts can often turn into a thrill ride that doesn't end well. High net worth or not, your hundreds of thousands, or even millions of dollars are no match for the billions being managed by professional managers and hedge funds. In commodities, fundamentals (supply and demand) will ultimately dictate what a bushel of wheat, a pound of sugar or a barrel of oil is worth. However, in the short term, speculative funds can move prices by shifting large amounts of money in and out of the market.

It is this hedge fund and institutional money moving around that makes timing and stop placement so difficult. Short term fluctuations often frustrate beginners and experts alike, stopping them out of positions even when their synopsis of the market will ultimately prove correct. This is a big reason why 80% of all futures traders lose money and the other 20% keep all of the money.

Enter Option Selling

Supply and Demand will ultimately dictate the value of a barrel of oil or a bushel of corn

By selling options, you immediately place yourself above this losing game with the funds. Not only are you no longer trying to predict what the market is going to do, you no longer have to pick when it's going to do it. With option selling, you are only selecting a price level the market will not reach (above or below the market) over a certain period of time. This means that short term market fluctuations will most often have little impact on your position. As long as the underlying futures price does not reach your strike prior to expiration, the option expires worthless and you, the seller, keep the premium collected as profit.

Commodities prices will ultimately have to reflect their underlying supply/demand fundamentals. This is why getting your fundamentals right is so important in commodities (see The Liberty Strategy). It is also what makes fundamental analysis and option selling such a potent combination. 80% of options held through expiration will expire worthless. Selling deep out of the money can improve those odds. Now sell deep out of the money based on a sound fundamental premise. You are stacking a lot in your favor here before the trade even begins. And you are taking away the advantage the institutional traders have over you. You are taking measures to put yourself in that elusive 20% and do it consistently.

Benefits to the Individual Investor

Time Decay

When selling (or writing) an option, time value works for you instead of against you. The buyer of the option pays you a premium for that option. If you sell an out of the money option, the entire value of that option is in time value. As time passes, all other things remaining constant, the option will gradually lose its value. It is for this reason that Liberty Trading pursues a strategy of selling deep out of the money options in client portfolios.

The closer an option gets to expiration, the faster its rate of time decay.

The graph above illustrates the principle of time decay and its acceleration as expiration draws near. An option is considered a "wasting asset." Time value erodes as each day passes, accelerating as the option's expiration nears. This is referred to as time-decay. If the underlying contract's price does not move to the option's strike price by expiration, the option will have no value left and expire worthless and the option seller will keep the premium. This is the concept on which our entire portfolio strategy is based. Notice that the value decays the fastest during the last 30-60 days of the option's life.

Taking Profits

One of the hardest parts of futures trading is deciding when to take profits. With option selling, if the market behaves favorably towards your position, you won't need to make this decision. As time value decays your option, the market will gradually take profits for you. Upon expiration, if the option is still out of the money (has not reached your strike price), the entire premium for which you sold the option will be in your account. At this time, your position automatically closes out. However, if your option has decayed to the point of being nearly worthless prior to expiration, you can buy it back at any time.

Lower Stress

When investing in the markets, the daily stresses of trading can wear on a person. Where to get in, where to get out, why is it moving, why is it not moving? It can lead to emotional decision making. Most of our clients tell us that selling deep out of the money options removes much of the stress and emotional decision making that is common in futures (or equities) trading. Although all futures trading carries some degree of risk, done correctly, option selling can place your position in the market far enough away that short term swings in the market may not dramatically affect your position. This not only gives you staying power but allows you to focus on longer term market fundamentals.

No More Trying to Pick Market Direction

Avoid the game of trying to predict where prices will go today, tomorrow or next week.

No matter what they say, nobody knows what any market is going to do, especially on a short term basis. However, do enough homework, and it is sometimes possible to make a fairly accurate projection of where prices will not go on a longer term basis. By selling deep out of the money options, you avoid the game of trying to predict where prices will go today, tomorrow or next week. Instead you are only projecting where you think prices won't go. For instance, if you are bullish the natural gas market, you might sell a deep out of the money put option. In this case, the market can move up, stay the same or even move down, as long as it is above your strike price upon expiration, you will still take your full profit.

What about the Risk?

Of course, option selling is not without risk. Taking steps to put probabilities in your favor does not mean you cannot lose money. The theoretical loss on an option sold uncovered is unlimited. Therefore an active program for managing risk and closing out losing positions is imperative.

While one can never completely eliminate all of the risk in any investment, there are many effective ways of managing short option risk. Your portfolio manager will discuss with you desired methods of handling this risk when you first open your account. Effective strategies can include stop loss orders, 200% exit rules, or "covered" credit spreads. Only risk capital should be used for selling options.

If this sounds interesting and you'd like to learn more about selling options in your portfolio, feel free to call our offices to set up a free consultation or you can also request an investors information pack Free on this website.