In last month’s edition, we introduced the concept of investing in commodities to the mainstream investor. This month, we explore a novel method of investing in this vehicle – a method that can produce a surprisingly high rate of success. It’s not magic – just unfamiliar to most.
The strategy is known as selling or writing an option on a commodities contract. You do not need to trade the actual futures contract when utilizing this approach – a comforting aspect to some. However, many traditional investors have difficulting grasping the concept of selling something you do not own.
Relax. “Selling” is simply a term used to indicate you are taking the opposite side of a buyer on a trade. “Writing” may be a more comfortable term for those attempting to learn the concept. Writing an option avoids the difficult game of trying to predict where prices of a commodity will go. Instead, writers of options are only picking a price level where they feel a market will not go.
In short, an investor analyzes a market – crude oil for instance. He deduces that prices will not dip below $40 per barrel over the next 4 months. He can then write a put option at the $40 strike price and receive a premium of say - $475. If the price of crude oil is anywhere above $40 at the expiration of that option, the options expires worthless and the investor keeps the $475.
The concept is similar to selling fire insurance to homeowners. As long as there is no fire, you keep all premiums collected as profit. If there is a fire somewhere along the way, you may have to pay out – depending on the severity of the fire. The key is picking neighborhoods and homes that are fire resistant. And, of course, owning your own fire company.
The CME estimates that close to 80% of all options held through expiration will ultimately expire worthless. If good odds are what you are after, this may be a strategy to consider.
If utilized correctly, option selling can be a very consistent investment approach. However, embarking on a campaign of blindly selling options at every turn is certainly not recommended (However, statistically this strategy should result in roughly 80% of them expiring worthless).
While you are now trading with percentages in your favor, the risks of writing options should be respected and any option writing approach should still carry the same disciplined trading plan and risk management rules as any traditional trading method.
Overview
I typically recommend using a combination of Fundamental and Seasonal analysis to project general price direction over a 2-3 month period. Then select far out of the money options with 3-5 months time remaining until expiration. Selling options with this amount of time remaining allows you to sell at strike prices that are very far away from where your underlying market is trading. This is what allows you to sell $40 put options when crude oil is trading at $70 per barrel. As an option seller, you do not have to be concerned so much as to where price 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.
Significance of Selling Options with Time Value Only
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 May Crude Oil was trading near $70 per barrel, a MayCrude Oil $72 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 on the option or time value. I do not recommend selling options with intrinsic value. On the other hand, if May Crude Oil was at $70 per barrel and a trader elected to sell a $40 put option, that option would be a full $30 out of the money and therefore have no intrinsic value. The full value of the option would consist of time value only. May 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.
As a seller of options, you want to sell time value. You want to put time on your side. In the example above, as long as May Crude Oil stays above $40, 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 futures price is above $40. Futures prices moving higher, in this example, would accelerate the deterioration of the option.
MAY 2010 CRUDE OIL
The benefit? If you are bullish crude and you sell a May $40 put, the market can move higher as you projected. But it is not necessary. Prices can stay the same or even move moderately lower. As long as the price is above $40 at expiration, the option will have no intrinsic value and expire worthless, allowing you, the seller, to keep all premium collected as profit. Traders bearish crude could utilize this same strategy by selling calls far above the market.
Suggested Time Value
There are significant reasons for selling options with 3-5 months of remaining time value.
- As discussed above, the physical commodities, especially 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.
- Writing Options with this much time until expiration also allows the trader to sell strike prices much further out of the money. Thus the market has a much larger cushion to move against his position without significantly affecting the value of the option. This gives the trader not only staying power but eliminates the need for perfect timing of a trade.
- This is often the time period that options enter the “sweet spot” of deterioration. An option value slowly decays over time but 2-3 months before expiration is generally when this deterioration begins to accelerate. Thus, a trader would want to sell the options right before this time period to collect maximum premiums and minimize his/her exposure. As the option begins to deteriorate in value, the chances of the option expiring in the money begin to decrease while the chances of it expiring worthless begin to increase.
Market Fundamentals and Option Selling
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. However, in my 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 idea, you’d better know the fundamentals of the market you’re trading, or be working with somebody that does.
Summary
Writing far out of the money options is an ideal strategy for trading long term fundamentals. By writing options, a trader not only gives the market plenty of room to make short term moves against his position, he forces the market to make a sustained, long term advance against the fundamentals for him to be stopped out of his position. He avoids all the technical “noise” that other traders are trying to interpret on a daily basis.
To write options effectively, you need not become an expert in option theory or spend 6 months learning the fundamentals of a particular commodity. There are several quality brokerage firms that do extensive research on each commodity and provide this research free to their clients. If you wish to begin writing options to take advantage of the probabilities it can offer, I do recommend working with an option writing specialist.
My firm offers a free information kit to investors interested in the approach.