Why Short Option Trading in Commodities?

Imagine how much better off you may have been had you sold every option that you have ever purchased.  While stories surface from time to time of traders that have attained huge profits from a single long option play, these tales are rare in comparison to those in which traders have lost some, or all of the premium paid for an option.

Selling options for the sole purpose of premium collection appears to be irrational to the novice trader.  After all, a strategy that involves unlimited risk and limited reward doesn’t appeal to most.  However, a closer look into the reality of the options market reveals an opportunity that even the most skeptical cannot ignore.

In a sense, option buyers are throwing good money after bad in a hunt of that one big market move that could “change their life”.  Given the assumption that markets spend approximately 80% of the time trading in a range, it is easy to see why few traders experience the abnormal returns that drew them to commodities in the first place.

By design, options are a depreciating asset.  Similar to the way that a new car buyer will witness the value of their purchase diminish once the automobile is taken off of the seller’s lot, an option buyer will experience time decay with every passing minute of the option's life.


The Anti-Trading Strategy 

A less exciting, but perhaps more fundamentally sound, approach to the markets is attempting to profit from a market that is trading in a range. Conceivably, the most efficient method of capitalizing on “quiet” markets is the short option strangle, often referred to as S.O.S.  However, short option strangles suffer during spikes of volatility and placement of strike prices well beyond known support and resistance levels are imperative.

Selling short option strangles is the act of selling a call above the market and a put below the market in order to collect a premium in exchange for assuming the risk of the market dropping below the put strike price or above the call strike price.  This is sometimes referred to as “trading naked” because the strategy involves theoretically unlimited losses.

The premise of an S.O.S. strategy is similar to the business model used by insurance companies.  Insurers collect premium on policies with the expectations of having future payouts.  Knowing the probability of a claim, they can project their expected return for assuming the risk of the policyholder.  They understand that, over time, they will profit despite their obligation to pay claims.  Thus, proponents of the S.O.S. strategy believe that it enables them to benefit from the probabilities as opposed to entering a position hoping to profit on a “long shot”.

Weighing Advantages and Risk of Short Option Trading in the Futures Markets

It should be obvious to you by now that there are clear advantages to selling option premium as opposed to paying for it.  However, beginning traders continue to be lured into long option strategies on the basis of limited loss characteristics.    Once again, the peril in this approach lies in the fact that although potential loss can be defined, I believe losses to be almost certain in many cases.  Most options expire worthless, and even those that expire in the money might not payout enough to cover the premium originally paid. With that said, it is important to note that putting the odds in your favor does not guarantee success but I argue that is a step in the right direction.  Doing so can be compared to the difference between rolling the dice and flipping a coin.  Naturally, you would want the 50/50 odds of a coin toss as opposed to a one in six chance offered by a dice roll.

We feel that if traders pay attention to technical aspects of a market as well as fundamental and most importantly seasonal tendencies,  this trading strategy could potentially be a dependable strategy in the long run.  That is not to say that there won’t be losers. As we all know, losing trades are inevitable.  The secret is to have the instinct and training to mitigate the damage caused by losing trades because when facing unlimited risk, the stakes are high. 

Premium Collection in Commodities, Volume and Volatility 

Before even considering selling options, traders should analyze a market’s “climate” and feasibility for the S.O.S trading strategy.  The two major aspects to consider include volatility and liquidity.

Volatility is an important factor of the extrinsic value of any given option.  Markets that offer enough action to keep option prices inflated but not so much that you can’t sleep at night, are ideal for the S.O.S. strategy.  Additionally, selling options is only practical if the option market is liquid enough to allow for easy entry and exit of a trade.  Trading in markets that don’t have lot of participants creates a scenario in which the bid / ask spreads can be massive, allowing for excessive slippage.  For these reasons, we have deemed that the one of the most advantageous markets to sell premium in is the S&P 500. 

Although the margin required for short option S&P plays are considered to be very hefty by some, the nature of the market allows traders to sell relatively wide spreads while still maintaining the potential of reaping a handsome reward.  For example, a short strangle 30-45 days prior to expiration with approximately 200 points between strike prices commonly yields $4.00 to $5.00 in premium, which equates to $1,000 to $1,250.  The average margin on such a trade is approximately $15,000. However, we recommend that a trader have at least $30,000 in an account in order to execute one S&P strangle.  It can be done with less, but that doesn't necessarily mean that it should be.  Following this guideline will give traders adequate capital to withstand potential fluctuations in both volatility and margin. While some futures traders snuff at this type of ratio for margin vs. potential return, traders must keep in mind the probability of success.  S.O.S. positions can make money if the market goes up, down or sideways.  The only catch is that the market can’t go beyond the strike prices. 

However, don’t be fooled into believing that being successful is as easy as selling a call and a put 100 points from the current market price and waiting for “pay day”.  There is much more involved in terms of skill and risk but I strongly believe that option selling is an optimal strategy if proper risk management techniques are exercised.


Don't Forget the Basics of Commodity Option Trading

Once a market is deemed to be suitable for S.O.S. trading, traders should evaluate the technical condition of the market in order to determine proper strike prices.  This includes trading ranges, support / resistance, Fibonacci rulers and any other technical analysis tool that you are comfortable with.

As you can imagine, traders who sell call options above significant technical resistance levels increase their odds of a successful trade.  Similarly, short put options should be placed below market support.  After all, even if a market penetrates support or resistance, it will likely stall before doing so.  To a short options trader, time is money.  As mentioned before, every passing minute diminishes the time value of an option.

It is imperative that traders are always aware of their intrinsic reverse break-even point.  At expiration, the reverse break even of an S.O.S. is equal to the strike price plus or minus the premium collected:

RBE on the Put Side = Strike – Total S.O.S. Premium Collected + Commissions and FeesR

BE on the Call Side = Strike + Total S.O.S. Premium Collected - Commissions and Fees 

The perfect scenario for selling strangles is a market that is trading in a definitive trading range.  This provides traders with the ability to “predict” the market’s range at expiration by extending the trend lines. I use the term predict loosely, as we all know there is no way to know the direction of the market with any certainty.  The best we can do is make an educated guess.  Let’s take a look at an example. 


2004 was ideal for option selling in equity index futures, the S&P 500 spent a majority of  the year in a trading range.  On May 18th, the market approached the lower lip of its recent boundary and appeared to hold.  Given that the last 30 days of an option’s life see the most depreciation, the June options expiring on Friday June 18th were very attractive.  This is also a great opportunity to sell overvalued puts.

Figure 1

S&P 500 Futures and Options Chart

The premise of S.O.S. is to increase the odds of success, thus selling a put with a strike price immediately underneath the projected bottom of the range is defeating the purpose of the strategy.  Thus, a trader should look to “give the market breathing room” by selling below support. On this particular day, according to hypothetical data available you could have sold the 1030 put for $6.00 in premium or $1500.  The 1175 Call would have collected $2.50 or $625 (values are based on the Black and Scholes Model).

Figure 2

S&P 500 Futures and Options Chart

Notice, that the spread is purposely constructed in a way that the risk and premium is over weighted on the put side.  This is because the market is up against heavy support and will likely reverse, or at least stall at this level.  Also, note that the Call strike is strategically placed above resistance.   

In this case, the June S&P futures contract does find support and climbs its way up to the upper end of the trading envelope.  Although, 1140 is tested the resistance is only briefly broken.  The market then drops back into the range to settle at 1132.25 on June 18, the day of option expiration.  While this example makes option selling look easy, I assure you that it is not always this convenient.

Trading ranges take some of the guesswork out of option selling, but unfortunately things don’t always work out so nicely.  Just as those trading outright futures contracts would, option sellers should consider technical analysis tools to determine strategy.  The most important consideration for option sellers is the placement of strike prices and the time frame of the option expiration.  Each trader will have a different idea as to which indicators and tools work, but the truth is you must pick those that you have confidence in.  In reality, I am of the opinion that they all have similar success ratios.

Positioning strike prices in a market that does not have a clear technical trading range can be much more challenging. Because support and resistance may not be as acutely defined, it is up to the trader to use a combination of technical tools and oscillators to find areas of support / resistance.   The tools and oscillators used will depend on the market environment, time horizon and risk tolerance.  Let’s take a look at an example of a trade that and the methodology that may be involved in the placements of strike prices.

Example 2: 

On August 8th of 2005, the S&P was in the midst of a bull run that began in late April.  The market was technically overbought, but in a definite up trend.  A quick look at the chart reveals that trend line support could potentially be found at about 1210 and then again at 1195 based on two alternative versions of an uptrend line.  The importance of drawing two possible trend lines is to keep your mind open to what your competition (other traders) might be looking at.  Even if the market breaks the first version, it may be prone to interfere with the market’s momentum.  Once again, this could translate into profits for a short option trader in the form of time erosion. 

Strike prices should always be placed beyond what is believed to be the most distant area of support or resistance.  Similarly, if there is a recent high/low beyond what you have deemed to be the final area of support/resistance, it should be considered in the placement of your strike price.  In this case, 1195 appears to be the distant trend line support however the market reached a low of 1185 on July 7th.  Thus, in our opinion selling an 1185 put is a preferable choice in that it gives the market sufficient room for normal fluctuation.

Figure 3 

S&P Futures and Options chart

Finding recent resistance in order to place our short call option required a little more research.  Because the market was trading near multi-year highs, we chose to use a monthly chart for our analysis. 


Short Commodity Option Trading with Fibonacci 

One commonly used technical trading tool is the Fibonacci ruler.  Using this tool we can make “educated predictions” as to where we think that the market might reach if it goes into a correction.  Fibonacci theory suggests that the market will move according to the “golden ratio”.  In other words, every market move will eventually lead to a correction in which the market could find support/resistance at the 38.2%, 50% and 61.8% retracement of the last move.  That is of course assuming that the bull run persists. 

Just like any other technical indicator, interpretation and measurements are somewhat ambiguous.  There are as many theories on where to begin measuring with the Fibonacci ruler as there are indicators themselves.  We believe that measurement should begin at the recent high or low subsequent to any measurable retracement.  Thus, when calculating the possible retracement levels in a down trending market, you wouldn’t necessarily begin measuring at the absolute high.  If the market peaked, and retraced at least 31.8% of that drop before continuing descent you should place the top of the ruler at the peak of that retracement.

After assessing the monthly chart, using a Fibonacci ruler, it is discovered that 1247.94 was the 61.8% Fib retracement from the high set in the fall of 2000.  We also noticed that the market had penetrated this level, reaching a high of 1249.60 in August, but failed to hold.  This suggested that the market was “tired” and ready for a short-term trend change.  Based on bearish observation of indicators, one may have opted to construct a strangle in which the call strike was much closer to the money than the put strike.  However, it isn't logical to sell a call at resistance.  It is typically a much  better strategy to collect a little less premium in exchange for a further out of the money strike price. While some might consider selling an asymmetrical strangle to be aggressive, and maybe even foolish, we believe that being aware of the market’s tendencies and using that knowledge to adjust the strategy is imperative for option sellers to succeed. 

Figure 4

S&P 500 Futures and Options Chart

Excessive analysis of the September S&P futures during this type leads me to believe that the most productive means of maximizing premium while mitigating risk would have been  through the sale of the 1185 puts and the 1260 calls. In this case, it may have  been possible to collect $11.30 in premium ($5 for the call and $6.30 for the put), this equates to $2825.   Hence, if everything goes perfectly and both options expire worthless the trade would be profitable by $2825 before considering commissions and fees.  Conversely, we typically recommend that traders offset short option positions before expiration which lowers the profit potential but more importantly mitigates exposure to loss once a majority of the premium has eroded. 

Figure 5 

S&P 500 Futures and Options charts

As expected, the market failed at Fibonacci resistance and drifted lower throughout much of August. As I mentioned, one of the keys to selling options is the ability to limit losses and risk whenever possible.  For this reason, you should make it policy to buy back short options once 80 to 90% of the value has eroded. Keep in mind that this is a rule of thumb, and there are a lot of variations.

In this case, it would have been possible to offset the short call position at 50 cents in premium, or $125.  To recap, we sold the 1260 call for $1250 and bought it back for $125 to get out of that leg of the trade once 90% of the value had eroded.  Thus, the profit on the call side of the strangle was $1125, and we were still holding the 1185 put. 

Looking forward, the September S&P found support on trend line support as the construction of the trade predicted.  On September 8th, the S&P was trading around 1235, and our short 1185 put had a value of $1, or $250.  With a little over a week to go to expiration,  it would be advisable to offset the final leg of the spread to lock in profits and take the  risk off of the table.


Better Safe than Sorry 

Going into the notoriously volatile period before option expiration with short option positions isn’t always wise.  Even options that seem to be so far out of the money that they couldn’t possibly end up hurting you should be offset.  For example, in this case the odds of the S&P rallying 25 points in week seem to be slim, however, you should never underestimate the market.  In attempt to squeeze another $250 out of an already extremely successful trade you could end up in the middle of a small disaster.  Remember, being greedy goes against the premise of this strategy and could easily turn a winning trade into a loser.

As with any trading strategy or method, losing trades are unavoidable.  Thus, it is important to point out that there is substantial risk involved.  Many option sellers fall victim to greed.  Failure to cut losses short can put traders at the mercy of the market. likewise failure to offset profitable options with little value left in them is a recipe for disaster in the long run.  Although the odds of a profitable trade are in the favor of the option seller relative to the buyer, instinct and the ability to make proper adjustments are crucial to making S.O.S.’s profitable.

**There is substantial loss in trading options and futures.



Futures and Options Trading Booksby Carley Garner

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