Increase the odds of Success in Commodity Option Selling
The practice of option selling is a controversial strategy for commodity option traders to partake in. Many brokerage firms outright forbid the practice; others allow it, but there are often strings attached. However, there are a limited number of brokerage services that recognize despite the challenges of option selling, it likely offers the highest long-term prospects for successful trading. Accordingly, such brokers give their clients the freedom to implement a short option strategy. We are a part of the minority commodity brokers that believe our clients should be given the opportunity to sell options without hassle. Nevertheless, option selling is far from an “easy-money” venture; there is a reason many brokerage firms shy away from option selling.
What is Option Selling?
Option sellers are in the business of collecting premium, much like an insurance company, under the assertion that in the long run the premium collected should outweigh any potential payouts. In a nutshell, an option seller is accepting the risk of the futures market trading beyond the strike price of an option, in exchange for income. For instance, a trader selling a $60 crude call for $500 is collecting $500 with the expectation that the price of oil will be below $60 at option expiration. If oil is above $60, the trader is exposed to risk similar to being short a futures contract from $60.00.
The premise of option selling is based on the assumption that more options than not expire worthless, which has been suggested by several studies including one conducted by the Chicago Mercantile Exchange. Unfortunately, similar to insurance companies who are sometimes forced to honor their policies on excessive claims, commodity option sellers are vulnerable to monster market moves than can be potentially account threatening. Preventing such disasters ultimately come down to timing of entry along with a good understanding of futures market volatility, market sentiment, and market knowledge. Additionally, experience, instinct and, of course, luck will also come into play. Yet, in my judgment option selling is a superior strategy in the long run.
Why do some brokers discourage or forbid short option trading?
Selling naked options leaves traders exposed to theoretically unlimited risk, while accepting the potential of a limited reward. In other words, it is the exact opposite payout diagram an option buyer faces (which is limited risk but unlimited profit potential). To the green trader, the prospects of being an option buyer is habitually more appealing. After all, who wouldn’t want the possibility of windfall profits with a finite risk? Notwithstanding the appeal, option buyers face a dismal likelihood of success. In other words, if the probability of bonanza style profits are slim then perhaps option buying is nothing more than the equivalent to buying a lottery ticket. The risk of loss is limited and maybe even small, but the odds of a return on the investment are also trivial.
The concern that most brokerage firms have with option sellers, isn’t that traders face unlimited risk. If that was the issue, they wouldn’t allow futures trading either (futures traders also face theoretically unlimited risk). The primary apprehension brokers have with short option trading is option market liquidity during highly volatile market conditions. The option market is not nearly as liquid as the underlying futures market, because of this it can sometimes be difficult to accurately value positions and account balances of option trading clients.
In other words, if a brokerage firm has a client trading futures in danger of losing more money than is on deposit in their trading account, the risk managers can easily assess the situation to determine if forced liquidation of positions is necessary. This is because they can see the exact price of the futures contracts and conclude the client’s account balance quickly and precisely. Ideally, any necessary forced liquidation would occur before the account balance falls into negative territory, but that isn’t a guarantee.
In a similar scenario with an option selling client, the risk manager might not have access to reasonable valuation or pricing. Not only does the lack of clear position valuation pose risk to the client and broker, it also requires more brokerage firm manpower and experience to manage the risk than futures trading account would. We saw an extreme case of this during the August 2015 downturn in the e-mini S&P 500 futures options (ES). Toward the end of a precipitous four-day decline, the bid/ask spread in most of the ES options was 10.00 points, or $500, in contrast to .50 in normal market conditions. In addition, option prices were increasing exponentially without reasonable limits. Those clients trading short options in high quantities could have easily seen tens of thousands of dollars vanish in an instant. Because the possibility of the spreads and option premiums “blowing up”, as it did in this scenario, housing short option trading clients requires far more brokerage firm risk management resources. As a result, traders should expect to pay more in commission for their option trades than they do futures trades.
Also complicating the issue, but for good reason, commodity exchanges don’t accept stop loss orders on options as they do futures. Thus, pre-emptive risk management isn’t a possibility. Stop orders are not possible on options because they are subject to widening bid/ask spreads, which in turn can trigger a stop loss order prematurely (stop orders are elected as soon as the market price reaches either the bid or the ask); it isn’t necessary for a trader to actually take place at the stop price to elect the order.
Deep discount commodity brokers cannot afford to let clients sell options freely because their profit margin is so tight. At a potential gross profit of pennies per trade, the extra work and potential debit account risk of allowing clients to sell options doesn’t make sense for their business model. Thus, if you are trading with a discount broker that is letting you sell options, you had better be aware of the fact that your positions are prone to heavy handed forced liquidation at the first sign of trouble. This is a massive disadvantage to an option seller; in my opinion it reduces the strategy to a sure fire way to lose money. Accordingly, be aware of your broker’s policy and “friendliness” to option selling before getting started.
Short option trading might still be a solid strategy
Now that we’ve discussed some of the risks and challenges of short option trading, let’s focus on the positive. The primary advantage of an option selling strategy is its ability to generate profits regardless of market direction. Further, an option seller can be wrong in regards to market direction and still make money. It is the only strategy that I’m aware of that offers such a high margin of error. Likewise, the odds of making money on any given trade are rather high. Generally speaking, an option seller can expect to make money on anywhere from 60% to 90% of trades. This is dramatically higher than most futures trading strategies which generally produce win/loss ratios of 50%, or worse. Similarly, long option traders might be lucky to win 10% to 20% of their trades. With these stats, it is easy to see why some traders are lured to an option selling strategy.
Naturally, a strategy that provides traders with such high odds of success on each venture must come with some sort of caveat…and it does. Losses on the few losing trades can easily engulf any profits made on the winning trades. Hence, it will take careful consideration and planning to successfully implement a short option strategy.
Here are a few ways to increase the odds of avoiding the “big loss”
Unless there is an obvious direction, sell strangles
Selling both a call and a put, known as a short strangle, is a method of increasing the premium collected while arguably increasing the odds of success. The favorable odds come from the fact that the trade can only lose on one side, but preferably neither. Risk exposure on one side of the strangle is partially hedged by the additional premium collected on the other side of the strangle. Simply put, the break-even point is shifted outward making it less likely for the trade to lose money (with all else being equal). With that said, not all market conditions are ideal for strangle. For instance, a market trading at an all-time low is prone to massive buying should the trend change. On the other hand, if there is no trend-change one directional trade could also put the short strangle in jeopardy. The ideal market to sell an option strangle is one that is neither at support nor at resistance, is not overbought nor oversold, and has a relatively equal probability of going either way.
Use 50% or less of your available margin
Option sellers can experience drawdowns whether or not the futures price ever reaches the strike price of their short option. This is because as futures market volatility increases, or the futures price moves toward the strike price of an option, the market might consider that particular option more valuable. Consequently, price discovery might assign the option a higher value than the original sales price. Sometimes spikes in option values are quick, and temporary; riding out the ebbs and flows requires extra funds in a margin account. Those attempting to sell options using the entirety of their account balance could find themselves forced out of positions prematurely and unnecessarily.
Wait for big spikes in volatility
If you have ever read a book on trading commodity options, you’re likely aware of the simple rule of being an option buyer when volatility is low, and a seller when volatility is high. However, we often underestimate the value of this rule. Selling options during times of high volatility equates to collecting more premium than is possible in a low volatility environment, or selling similar premium using options with distant strike prices. Each of these scenarios increase the probability of a favorable outcome relative to a comparable strategy in a quiet market because it would require the futures price to move further to create a losing scenario.
To illustrate the importance of waiting for high levels of volatility, let’s take a look at the value of some Euro currency futures options on August 18, 2015 and the comparable options on August 24, a short week later, but after a volatility spike.
On August 18th, a trader could have sold a straddle (an at-the-money call and an at-the-money put) using the October expiration for about 170 ticks per option; this equates to $2,125. In other words, the total straddle could be sold for $4,250 ($2,125 x 2). On August 24th, a straddle could have been sold for 180 ticks, or $2,250 per option. This equates to $4,500 in premium collected per straddle. Keep in mind, that options generally erode over time so the fact that the same strategy (an at-the-money-straddle) is worth more nearly a week later is significant. With that said, on a trade such as this a difference in premium collected of $250 might not be a game changer, but those selling out-of-the-money strangles will see a massive advantage.
A strangle trader, who sells out-of-the-money options as opposed to a straddle trader, looking to collect 60 ticks in premium, or $750 on August 18th could have sold a 1.155 call and a 1.055 put. Keep in mind, a strangle trader reaps the maximum profit if the futures price is between the strike prices at expiration. In this case, the trade would be profitable by 60 ticks, prior to consideration of transaction costs, at expiration if the euro is anywhere between $1.155 and $1.055. If you’ve done that math, you’ve realized this provides a max profit zone of 10 cents (1,000 euro ticks), which is quite substantial. However, had a trade waited until the 24th to sell a strangle for 60 ticks, she would have been able to get the premium she was looking for by selling the 1.2250 call and the 1.1050 put, this expands the profit zone by 200 euro points! The second version of the strangle now offers the trader a max profit zone of 12 cents, or 1,200 euro ticks. Naturally, the wider strangles increases the likelihood of success and dramatically reduces the probability of a high stress trading venture.
Sell options with strike prices beyond support and resistance
Essentially, an option seller is collecting a premium in exchange for the risk of the underlying futures market trading beyond the strike price of the short option. Placing the strike price of any sold options beyond known support and resistance sounds like an obvious strategy, but it tends to be overlooked as traders seek more premium and disregard risk. Nevertheless, proper strike price placement is a very effective way of shifting the odds favorably.
Know the volatility tendency
Most markets have a particular direction in which they are capable of the most explosive moves. For instance, the stock market tends to take the stairs up and the elevator down. As a result, put options tend to be relatively expensive when compared to calls in the e-mini S&P 500. Even more so, S&P puts are prone to massive panic pricing in a volatile down-turn. However, S&P calls generally don’t have an explosive pricing nature. Crude oil and the grains, are typically the opposite; they have the potential to move higher faster than they can move lower. Knowing this, extra caution should be warranted when selling puts in a quiet S&P environment, or calls in a quite grain market.
Option Selling is not for everybody due to the prospects of theoretically unlimited risk. Yet, it is a strategy that everyone should consider in light of the high probability of success on any particular trade.
*There is substantial risk of loss in trading futures and options. There is unlimited risk in option selling!