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.
