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.

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

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.

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. And make no mistake, you can still lose money. Yet the misunderstood risk of selling option premium is what keeps so many otherwise rational investors away from the strategy. The term "unlimited risk" has been all that is needed to scare curious investors away and bring them right back to strategies their broker wants them in — namely strategies the broker understands such as buying options or buying the underlying stock or futures contract.

Granted, there is no free lunch. For the great odds and the large majority of winning trades you will have, there will be a small minority of positions that could result in losses which can run if left unchecked.

There is one key method of minimizing this risk, however. It is called "exiting your position". A loss is only unlimited if you don't limit it yourself. It is the art of when, where and how to exit that causes so much confusion among beginning option sellers (thus the reputation).

While one can never completely eliminate all of the risk in any investment, there are many effective ways of handling short option risk. Unlimited risk simply means that the market will not limit your risk for you. It has to be done "manually". 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 for the truly conservative, covered credit spreads.

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.