My favorite options strategy for futures markets

With the stock market stuck in the doldrums, many mainstream investors are starting to consider alternative investments as a means to hedge or outright replace their portfolio’s equity holdings. One such alternative that has gained a large investor following as of late is the commodities market. Despite what many conservative financial advisors preached in the '80s and '90s, investing in commodities is going mainstream and with the current trend in commodity prices, it is no wonder why these markets are attracting so much attention.

With energy prices making all-time highs, precious metals such as silver reaching levels not seen since the Hunt brothers were making headlines, and many agricultural products in short supply due to world economic growth, many investors with no prior experience have been testing the waters of this highly leveraged, and often misunderstood investment vehicle.



Investing in commodities, however, is not for everyone. With the leverage comes faster and sometimes sizable profits. But leverage can also result in the opposite effect of faster and more significant loss. Despite the CRB monthly index, individual commodities markets can fluctuate up and down to different degrees on a daily, weekly or even monthly basis. Because of the leverage, they are most often traded on a short-term basis rather than buying and holding for the long term. While commodity index funds have gained more popularity in recent years, most individual investors get their first taste of futures by buying a contract of crude oil or selling a contract of gold. If their outlook for prices of the particular commodity is correct, they can reap a substantial profit.

The caveat, of course, is that one must be on the right side of a particular market when it decides to move in its chosen direction. What many new traders do not realize is that it is nearly impossible to consistently guess at the short term direction of any market. In addition, because of the leverage in futures contracts, many investors are forced to place stop orders very close to their entry levels, meaning even if they accurately predict the ultimate market direction, they will often be stopped out before the market makes the move they were anticipating. This is why many new investors will lose money in commodities and miss out on much of the price movement happening in today’s markets.

But what if a trader did not have to decide? What if he did not have to determine which way the market was going to move? What if, in exchange for giving up his chance to make a large windfall with one big move, one could free himself from the daily whims of the market and settle for making smaller, yet surprisingly consistent gains over and over? In this situation, your profits would be limited on each individual trade, but your probabilities of success on any individual trade would be high.

If this type of investing sounds interesting, then the strategy of selling options might be for you.

In selling (or writing, as it is sometimes called) options, one does not have to decide where the market is going to go. One simply has to decide where the market is not going to go. He selects a price level above or below the market that he believes the market will not reach within a certain time period (for our purposes, generally 30-60 days). He then sells an option at this price level and collects a premium for doing so. If the time period elapses and the market has not attained this price, the option expires and the investor who sold it keeps the premium he collected as a profit.

The approach, in and of itself, is similar to the one used by insurance companies across the globe.

Is there risk in this strategy? Of course. But no more risk than in buying or selling a futures contract. And in many cases, much less. Just like an insurance company, you will have to pay out from time to time. But remember, insurance companies make hefty profits by collecting many premiums, but only paying out on a few. If you begin selling options, you would be operating this way, too.

I once had a trader ridiculously argue with me that selling options takes all the “fun” out of trading commodities. Maybe so. But if you are like me, you are not investing for fun--you are investing for profits. This gentleman’s argument was offset by another conversation I had a few months later with an elderly gentleman who called in to inquire about working with us. After exchanging some initial information, he told me he wanted to work with us because he liked selling options and that was the only strategy he used. I asked him why he only sold options. His response was one I’ll never forget because it captures the entire rational for selling premium.

His response was “Because I’m not a very good trader. Selling options is the only way I can make money in the market.”

This quote has stuck with me through the years and I liked it so much I put it in our book. However, this in no way should suggest that option selling is the holy grail of trading or that the strategy is a sure way to fast returns. Selling option premium in the futures markets is still a highly leveraged endeavor. While the odds do favor the seller, losses can and do occur. Selling puts or calls in the futures market is not for the squeamish and you should be sure that before investing, you have a good idea of the risks involved, the markets you are trading and how they work. You may want to consider working with somebody who is familiar with these concepts. It is a good idea to commit only the more aggressive portion of your portfolio to this type of investment. In other words, keep Junior’s college fund in the CD.

While the strategy of option selling is far to complex to condense into a single article, we hope to be able to give you enough information in this piece to decide if the investment strategy may warrant further study for your portfolio.

For those unfamiliar with options, an option is a contract that gives the owner the right, but not the obligation, to buy or sell a specific commodity or security at a specified price. However, the buying or selling of these options is a market in-and-of itself. Many traders like to buy options because, for a small premium, they can gamble that the price of a specific commodity or equity will make a large move in their favor. In most cases, the market will have to move quickly and dramatically in favor of the option buyer for the option buyer to make money.

Buying options is generally a favorite strategy of small, individual investors trying to take a small amount of capital and turn it into a large payload. The statistic that these speculators ignore is that it has been estimated that options held to expiration will expire worthless approximately 80% of the time. This means that the premiums buyers pay to purchase these options will be lost approximately 8 out of 10 times.

But where do these premiums go? To the sellers, of course. Selling options has been a base strategy of professional traders and commercial hedgers for years. They sell options, and small, generally lesser capitalized investors buy them. Most of the time, the options expire worthless and the professionals and commercials take the money. This is why we recommend the strategy of selling options to our clients.

Options are traded on the open market, just like futures contracts or stocks. They can be bought and sold just as easily as buying or selling a futures contract or a share of stock. Most major futures markets also offer a corresponding option market for each contract. For instance, if one wanted to trade gold, one could buy or sell a gold futures contract, or one could choose instead to buy or sell gold options. The options, of course, are based on their corresponding or underlying market. Therefore, if one bought or sold a February Gold option, it would be based on the February Gold futures contract.

There are two types of options, puts and calls. At the risk of oversimplifying the difference, buyers of calls want the market to move up, buyers of puts want the market to move down. These option buyers generally believe the market is going to move towards or eclipse a specific price level. With options, this specific price level is referred to as the strike price. An option will generally show its greatest increase in value after the market has moved beyond its strike price. It is for this reason that buyers of options generally need the market to make a moderate to large scale move in order to show a profit. Most of the time, this will not happen. However, occasionally, a market will make a considerable move in favor of the investor in which case his small investment in the option can show a substantial profit. This is what attracts small speculators to option buying.

Sellers of options, however, do not require the market to make a big move in order to profit. An option seller wants the options to expire worthless – for in that circumstance, he makes his profit. And the option will expire worthless as long as the strike price has not been reached. Therefore, unlike the option buyer, he can profit if the underlying market moves in his favor (away from the strike price), remains steady, or even if the market moves moderately against his position. The risk to the seller is that the underlying market price moves beyond the strike price of the option. There are, however, many ways to manage this risk. Several of these are discussed in our book, The Complete Guide to Option Selling (McGraw-Hill 2005).

For the purposes of this segment, the example below illustrates the concept of selling an option. For this example, we are supposing that an investor is neutral to bullish the natural gas market.



In June 2006, with September Natural Gas trading near $7.00 per BTU, an investor is neutral to bullish the natural gas market over the long term. However, high storage levels have him uncertain about the short term direction of the market. Rather than trying to outguess the futures market in the short term or buy a call option above the market and hope it moves up quickly, this investor chooses to sell a September Natural Gas 4.50 put option. He places an order to sell the option in the open market at the New York Mercantile Exchange (NYMEX). For this example, we will assume he receives a premium of $700. He will have to put up a portion of his own money to hold this position. This is called margin. For this example, the margin the trader would have to utilize would be about $1,300.

Every option has a set expiration date. September natural gas options expire on August 28th, 2006. If September natural gas is anywhere above 4.50 at option expiration, the seller of the 4.50 put would keep the $700 premium collected as profit. He would, of course, keep his margin deposit as well.

Conversely, for the buyer of the 4.50 put to show a profit at expiration, September natural gas would have to be trading somewhere below 4.50 on expiration day. The option seller would lose in this scenario.

Traders bearish a market can utilize the same strategy, albeit with call options. For example, a trader eying the large 2006 Brazilian Coffee crop may be of the opinion that coffee prices will have a hard time rising in such an environment. This is an important distinction. We did not say he felt that prices would necessarily go lower. He is only investing with the idea that prices will not rise substantially. If prices do move lower, all the better. However this is not necessary for the trader to profit. This concept is illustrated below:



In May, with coffee trading near $1.15 per pound, the trader does not know if prices will move lower (who does?) but feels that with the supply situation, prices will have a hard time moving significantly higher. He therefore elects to sell a September Coffee $1.60 call for $420. To do this, he posts a margin of roughly $890 (estimated based on SPAN margin). This gives the market plenty of room to move against him and still allow him a profit. If September Coffee is anywhere below $1.60 at option expiration on August 11th, the trader keeps the $420 premium as profit. As you will note from the chart, this trader did not have to worry about that, as prices would have indeed moved lower after this fictitious trade. But it is comforting to many investors to know that there is plenty of room, even if they are initially wrong on market direction.

“That sounds too easy,” prospective investors will often tell us, “If that is the case, why isn’t everybody selling options? And by the way, who would buy an option like that?”

These are good questions that do have good answers. First of all, option selling does have a downside, for as we all know, there is no free lunch. While the call option in this example will indeed expire worthless if the price of coffee is below $1.60 at expiration, the value of that option can increase if the market moves toward the strike price in the interim. If this increase is substantial, it can become uncomfortable for the investor holding the call from the short side. If he decides to hold the option, it could require more margin capital from the investor's account. He also would assume the risk that the market keeps moving higher until his call option goes “in the money”. This could mean a larger loss. Many investors will simply buy their option back to close the position if the market moves beyond their comfort level, even if it means doing so at a loss. This is a strategy that we happen to agree with. Therefore, although the odds of success are favorable in selling options, the risk of loss is still present and traders should have a solid risk management plan in place before embarking on an option selling campaign. That is why “everybody” is not selling options.

As to who buys options, I believe we have already answered that question earlier in this article. Professional traders generally consider buying options to be a legitimized form of gambling in which the option buyer will probably lose his investment, sooner or later. The professional knows that by utilizing some basic fundamental research, he can potentially profit 80-90% of the time by selling options. The key to long-term success is managing the risk on the smaller percentage of options that do not expire worthless.

Of course, one should do a careful undertaking of the risks involved in option selling before deciding if the strategy is right for him. However, professionals know that that by managing their risk correctly, they can avoid loss much of the time and keep a large percentage of their premiums as profit.

Professionals play the percentages. By selling options in your portfolio, you can too.

If you would like to learn more about selling options in a diversified portfolio, visit us on the web at www.optionsellers.com. Or email us at Office@libertytradinggroup.com

James Cordier is head trader at Liberty Trading Group, a full service futures brokerage specializing in option selling portfolios. Mr. Cordier appears regularly on CNBC and Bloomberg television to discuss commodities prices. Michael Gross is director of research at Liberty Trading. Mr. Cordier’s and Mr. Gross’s book, The Complete Guide to Option Selling (McGraw Hill 2005) is available at bookstores and online retailers.

***The information in this article has been carefully compiled from sources believed to be reliable, but it's accuracy is not guaranteed. Use it at your own risk. There is risk of loss in all trading. Past performance is not necessarily indicative of future results. Traders should read The Option Disclosure Statement before trading options and should understand the risks in option trading, including the fact that any time an option is sold, there is an unlimited risk of loss, and when an option is purchased, the entire premium is at risk. In addition, any time an option is purchased or sold, transaction costs including brokerage and exchange fees are at risk. No representation is made that any account is likely to achieve profits or losses similar to those shown, or in any amount. An account may experience different results depending on factors such as timing of trades and account size. Before trading, one should be aware that with the potential for profits, there is also potential for losses, which may be very large. All opinions expressed are current opinions and are subject to change without notice.

Price Charts courtesy of CQG, Inc.