The Liberty Trading Strategy

Using Time Value, Distance and Pure Market Fundamentals

Intro to Option Selling part2
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Deep out of the money options tend to stay out of the money, if not deep out of the money.

— Investorglossary.com

There are many different ways to approach selling options. The portfolio strategy you will learn here, however, is one that, in our opinion, offers the highest overall probability of success while providing the easiest and most efficient means of managing risk. This approach revolves around three main themes: Knowing your fundamentals, selling options with more time, not less, and selling options deep out of the money.

Deep Out of The Money (definition) — An option which is so far out of the money that it is unlikely to go in the money prior to expiration.”
- Investorwords.com

Deep out of the money options tend to stay out of the money, if not deep out of the money.”
- Investorglossary.com

The odds of a deep out of the money option going into the money are very low and as such, the delta is very low for these options.”
- Options Moneyness, www.mysmp.com

Overview

Liberty Trading uses a combination of Fundamental and Seasonal analysis to project general price direction over a 3-4 month period. Options are then selected with 3-4 months time remaining until expiration. As an option seller, you do not have to be concerned so much as to where prices will go, but more so, where price will not go. You therefore want to select price levels that could only be achieved through a radical change in fundamentals. The object is to select the options with highest probability of expiring worthless, even if you have to wait a few months for them to do so. In other words, you want to sell Deep Out-of-the-Money Options. This strategy can be utilized effectively over a wide variety of diversified markets, keeping small positions in each, and a sizable holding of back up cash.

Significance of Selling Options with Time Value Only

Intrinsic Value

An option's value is made up of intrinsic value and time value. Intrinsic value is how much the option would be worth if it was exercised today. In other words, it is how far it is in the money. For instance, if August Crude Oil was trading near $52 per barrel, an August Crude Oil $54 put option would have 2 dollars worth ($2,000) of intrinsic value. The rest of the value of the option would consist of how much time was left (prior to expiration) on the option (time value). We do not recommend selling options with intrinsic value.

Time Value

On the other hand, if August Crude was at $60 per barrel and a trader elected to sell a $30 put option, that option would be a full $30 (50%) out of the money and therefore have no intrinsic value. The full value of the option would consist of time value only. August Crude Oil would have to fall a full 30 dollars per barrel before the option would go in the money and have any intrinsic value at all.

By selling Deep-out-of the-Money options, you force the market to make a major move against your position in order for you to lose on the trade.

As a seller of options, you want to sell time value. You want to put time on your side. By selling Deep-out-of the-Money options, you force the market to make a major move against your position in order for you to lose on the trade. In the example below, as long as August Crude Oil stays anywhere above $30, the option will not have any intrinsic value. As its only value is in time, as time passes, the option's time value will erode, slowly at first, then rapidly at the end. Of course, movement in the futures market can temporarily affect the value of the option as well. A move lower could temporarily push the value of the put option higher, but it will still have no intrinsic value if the crude oil futures price is above $30 per barrel. Futures prices moving higher, in this example, would accelerate the deterioration of the put option.

Example: August '09 Crude Oil

In May 2009, crude oil hovers just above $60 per barrel. The market seems to have priced a global demand slowdown but looks forward to an approaching driving season. Trader John wants to benefit from what he feels will be steady to higher oil prices but is fearful of getting stopped out on a correction. Therefore, instead of buying a call or buying a crude oil futures contract, John decides to sell an August $30.00 put option. In doing this, he collects a premium of $500. Now the market can move higher as John projected, stay the same, or even move moderately lower. As long as the price of August Crude Oil is anywhere above $30 at expiration, the option will have no intrinsic value and expire worthless, allowing John, the seller, to keep all premium collected as profit.

If crude oil prices continue to trek higher (as they did) this market could have been profitable for call buyers, futures buyers and put sellers. However, should the funds get spooked and go into a round of selling, it is likely that John (with his put selling strategy and strike price way down at $30) will be able to remain in his position while most of his futures trading buddies are running for the doors. His call buying friends will most likely require a sharp, fast rally and an optimal exit strategy to profit. But John is not trying to hit the "home-run". He only needs to "hit singles" but do it over and over again. John knows that with option selling, all he has to do to win on his trade is not to lose.

The Benefit of selling puts in this example? If John is bullish crude and he sells an August $30 put, the market can move higher as he projected. But it is not necessary. Prices can stay the same or even move moderately lower. In this example, if John holds the option until expiration, and the option remains out-of-the-money, it will expire worthless and John will profit $500 (original premium collected) for every option sold.

If crude oil prices move below $30, John could experience a loss on this trade. However, John can buy the option back to close the position at any time prior to expiration, at market price. This could result in a profit or loss, depending on what the value of the option is at the time.

Example: August '09 Crude Oil

see the full example

Past profits are not necessarily indicative of future results. Any profits represented are for example purposes only and do not include transaction fees.

Suggested Time Value

...if the market moves favorably, one can often take profits (buy back) these options long before expiration.

In the example above, did you note that the strike price is 50% out of the money? One huge benefit futures options have over equity options is the distance at which far out of the money options can be sold. Liberty recommends selling options that are at least 50-100% of out the money. This often means selling options with more time (generally 3-5 months). But don't let this intimidate you. While this may seem like a long time, if the market moves favorably, one can often take profits (buy back) these options long before expiration. And you will rarely have to deal with the prospect of an option going in the money. However, there are other good reasons for selling this far out with commodities options. These are explained below.

Reasons for selling options with 3-5 months of remaining time value.

Selling further out in time value does entail the risk of allowing the market more time to move against your position which could result in your option premium increasing in value and potentially incurring a loss. However, we favor this strategy for the following reasons:

As discussed in the next section, the physical commodities, especially energies and agricultural commodities such as Coffee, Soybeans or Sugar, generally have fundamentals (such as warehouse supplies, consumption trends, or planting and harvest cycles) that do not change over the course of a few months. By positioning only in markets with the most clear cut fundamentals (bullish or bearish), a trader can sell options with added confidence in his position, knowing that for his option(s) to ever go in the money, the market must make a sustained, long term move that is contrary to the fundamental factors that ultimately should determine price. Selling short term (30 day) options will often work. However, this means selling strikes very close to the money where the slightest twitch of a fund managers finger can put your option in the money. Remember, you're after consistency, not a quick buck. Not even the powerful funds can buck the core fundamentals for too long. So you study your fundamentals and stay far above or below weekly trading ranges.
Writing Options with this much time until expiration is what allows you to sell strike prices so far out of the money. It's value is held in time. Thus the market has a larger cushion in which to move against your position without significantly affecting the value of the option. This gives you not only staying power but eliminates the need for perfect timing of a trade. Volatility in the markets will often increase the availability of more distant strike prices. This is why markets trading at elevated volatility levels are often excellent candidates for an option selling approach.
This is often the time period that options enter the "sweet spot" of deterioration. An option value slowly decays over time but 2-4 months prior expiration is generally when this deterioration begins to accelerate — especially if the options are deep-out-of-the-money. Thus, you want to sell the options right before this time period to collect maximum premiums and minimize his/her exposure. As time begins to decay the option's value, the chances of the option expiring in the money begin to decrease while the chances of it expiring worthless begin to increase. This is why deep out of the money options often turn to "dead" options long before expiration.

Market Fundamentals and Option Selling

...eventually, prices will have to reflect the fundamentals factors of any given commodity.

In our opinion, technical indicators can be an effective tool in projecting short term moves in the market. However, eventually, prices will have to reflect the fundamentals factors of any given commodity. Many traders and even brokers use technical analysis as their sole means of trading, simply because they don't know the fundamentals or they don't have access to the resources that are necessary to gain timely, relevant fundamental data. Learning the fundamentals of a market and how they can affect price can be time consuming and difficult.

In our opinion, trading solely on a technical basis is like trying to hit a baseball with one eye closed: your perspective is going to be off. If you're investing capital into a commodity trading portfolio, you'd better know the fundamentals of the markets you're trading, or be working with somebody that does. Markets can experience impressive looking breakouts to the upside or downside, but without the corresponding fundamentals to support such a move, a sustained trend is highly unlikely. Often times, a chart breaking out in defiance of clear cut fundamentals can be an excellent option selling opportunity as many traders will tend to buy calls or puts in the direction of the breakout, driving premiums disproportionately higher. The following example illustrates this concept.

example: fundamentals and option selling

In September of 2007, reports of dry weather in Brazilian growing regions brought a wave of fund and spec buying into the Coffee market, causing a technical breakout above key resistance near 1.29 per pound. Commercials (who often trade fundamentally), aware that September is almost always dry, watched the scenario play out and then began locking in higher prices near 1.37 -1.42 per pound. This heavy commercial selling drove the market back through the spec stops, further igniting a downward move. Timely rains did begin to arrive in October, getting the 08 Brazilian coffee crop off to a good start. The 2008 Brazilian coffee harvest produced close to 50 million bags of coffee - one of the largest harvests on record. The market, of course, ultimately had to adjust lower. These are the realities of fundamentals.

A pure technician might have bought the breakout above 1.29, 1.35 or 1.40 and even could have netted a decent profit - had he sold right before the drop. However, this was a rally led by speculation and not based on the true fundamentals ultimately affecting coffee prices. Spec led rallies are almost always fickle and tend to start quickly and end quickly. A trader aware of the bearish fundamentals (seasonal weather and expected crop yields) hanging over the market probably wouldn't have touched it. But how should he take advantage of this knowledge? Should the investor try to time a point to short the futures? Not advisable.

Coffee March 08 Rally

What if the investor could sell calls far above the market at strike prices nearly 100% above the current price of the commodity? In the breakout in the example above, a trader could have sold March 270 coffee calls for premiums of $400 each. As long as coffee prices do not experience a 100% increase in value (heading into what could have been the largest Brazilian coffee harvest ever), the option will expire worthless.

March '08 Coffee Showing 270 Call Strike

The example above was an excellent call writing opportunity as the premiums inflated on the break out. The trade would have netted a quick profit when the market moved lower very rapidly. However, if the option seller's timing had been off, or if coffee had rallied for a few more days or weeks, his position was still "miles" above the market. A continuance of the rally would still have allowed him to hold his fundamentally based position, a luxury the futures trader would not have enjoyed (unless he would have been willing to post a substantial margin to cover his losing position). In other words, the option value would have increased, but probably not significantly enough to force the trader out of his position.

Ultimately, this did not happen and these options were "dead" by December.

Why can these options be sold so far out of the money? One, because the leverage structure in commodities makes it feasible. But also because historic volatility, in this case, allowed it. Spec traders still remember the "glory days" of coffee in the mid 90's when coffee prices soared above 2.00 per pound and they are still willing to take a chance that it will go there again. However, the fundamental scenario in the coffee market today is very different from what it was in the early and mid 90's. An investor educated in the fundamentals knows this and can use it to his advantage.

Coffee prices experienced a similar pattern in the Spring of 2009 before shortages were alleviated by the Brazilian harvest. It was the same set up for the same trade.

You can follow our regular updates on the coffee market on our Market Commentary page.

Example: Fundamentals and Option Selling

March '08 Coffee

see the full example

Past profits are not necessarily indicative of future results. Any profits represented are for example purposes only and do not include transaction fees.

summary

In our opinion, writing deep out of the money options is a custom tailored strategy for trading long term fundamentals. Unlike equities, commodities are physical products that people will always need. A pound of sugar and a barrel of oil will always have a value. And that value will ultimately be determined by it's supply vs. it's demand. By writing deep out of the money options, you force the market to make a sustained, long term advance against the fundamentals for you to be stopped out of your position. You avoid all the technical "noise" that futures traders are trying to interpret on a daily basis. And perhaps most importantly, you trade glory for consistency. It's the year end return that counts — not the one time killing.

We do not mean to dismiss technical trading as useless. Quite the contrary, we advise using key technical indicators to time entry into short option positions. However, if you are selling options with any amount of time value, the fundamentals of the particular commodity should be given strong consideration in selecting markets in which to write premium.

A Final Note

Do not feel that to write options effectively, you must become an expert in option theory or spend 6 months learning the fundamentals of a particular commodity. Remember, you will be working with the option writing specialists. Liberty Trading Group is one of the few firms in the nation to specialize exclusively in selling options. Our research is focused on knowing the fundamentals of a select group of commodities and then applying option knowledge to identify trading opportunities. Sharing market commentary with several worldwide news services such as Dow Jones News, CNN Money and Reuters on a daily basis allows us access to these individuals in researching crop ratings, historical yield comparisons, consumption trends, usage figures, etc, in commodities produced worldwide. Should you choose to become a client of our firm, you will not only have access to this information, but receive professional guidance in positioning your portfolio.

For more information about what you receive as a client of our firm, please visit our Account Information page or request a Free Investors Information Pack.

If you have any questions about the trading strategy or portfolios with our firm, please feel free to call us at 800-346-1949 or 813-472-5760 (for international callers).

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The Liberty Trading Strategy

Using Time Value, Distance and Pure Market Fundamentals