Option Selling Part 5 - Strangles, SPAN Margin

The Canadian dollar is currently around 94 cents to the US dollar. With the weak U.S. dollar, Canada's stronger economy, news such as Russia diversifying into Canadian dollars, I think the fundamentals are strong for the CAD, and I'm very certain it will stay over 82 cents over the next couple of months.

I can (and did) sell 2 March puts (about 100 days to expiry) at a strike price of 82 cents. I received $640 for this sale, and it required $1200 margin. This means I will make about 50% in 100 days on this trade if the CAD/USD exchange rate stays over 82 cents.

Now, I also think the CAD price will be kept in check and will not skyrocket to $1.10 in a short period of time. With the US dollar so beaten down, there may even be a short-term US dollar rally here. I am able to sell 2 March calls at a strike price of $1.06 for a $560 premium. By itself, this trade would normally require around $1100 margin. So we can guess our total return and margin requirements are as follows:

Trade                                Premium     Margin

----------------------------------------------

Sell 2  0.82 March Puts         $640      $1200

Sell 2  1.06 March Calls         $560      $1100

Total:                                  $1100      $2300      
$1100/$2300 = 48% ROI.

However, this is not what really happens. In futures trading, margin requirements are calculated using a special algorithm called SPAN margin. The algorithm is a secret (you have to pay $1000 or something to even buy a program that will calculate it for you, although your broker has the program and will calculate it for you). All you need to know is that it calculates a 1-day risk value on your entire portfolio covering 16 different scenarios.

If you look at our trade above and really think about it, we didn't add much risk by adding the 2nd trade. If the CAD moves significantly in one direction, the losses in the one option will be partially, if not mostly, covered by the gains in the other option. E.g. if the CAD goes to 98 cents, the 1.06 calls may double in value (+$560), but the puts will then also drop to maybe $200 (-$440), so we've effectively hedged our position pretty well. The SPAN calculation recognizes this since it analyzes our whole portfolio, and thus only requires an extra $500 margin for adding the 2nd trade instead of a full $1100 if the trade were by itself.

With SPAN margin, our trade actually looks like this:

Trade                                Premium     Margin

----------------------------------------------

Sell 2  0.82 March Puts         $640      $1200

Sell 2  1.06 March Calls         $560      $500

Total:                                  $1100      $1700      
$1100/$1700 = 65% ROI.

A trade like this where you both sell a put and sell a call in the same expiration month is known as a Short Option Strangle, which I'll just call a Strangle from here on (because we're always "short" by being sellers of options).

I love strangles because you simultaneously increase your ROI while lowering your risk, which is totally counterintuitive -- normally to increase your ROI you have to take on more risk.

You could argue that you are taking on some more risk with a strangle, because a major market move in either direction is now bad for you, whereas with a single position, the market has to move in a specific direction to affect you negatively. However, I believe this type of risk is more than offset by the hedging nature of the trade.

In fact, if you follow a strict rule of exiting both trades and repositioning the strangle if one of the option's value doubles, you almost can't lose money. As I described earlier, if the CAD moved up to 0.98 and the call option doubled, you could probably exit the trade for less than a $200 loss. You could then place a new strangle at a higher price range, say 86 cents and $1.10, again for a total $1100 premium. Even if you had to reposition your trades like this 5 times until you were finally successful, you'd still break even in the end!

I try to do strangles whenever it makes sense. However, when the sentiment on a commodity is really bullish or bearish, it can be too difficult to do a low risk strangle. Right now, many commodities have a lot of bullish sentiment, and so the puts are practically worthless until you get to the strikes that are quite close to the current price -- too close for our comfort as far out-of-the-money option sellers.

Option Selling - Part 4 - Futures Options vs. Equity Options

Here's an article by the book authors that summarizes the advantages of selling options in the futures markets versus the equities market:

http://www.traderslog.com/optionscomparison.htm

It really boils down to the 1st reason listed: margin requirements are way less in the futures markets, meaning your ROI is much higher.

I can typically sell a far out-of-the-money futures option with 3 months to expiry and receive a $500 premium, while only requiring about $1500 or less to be set aside (the margin). That's a 30% return in 3 months. A similar type of trade in the equities market supposedly might get you a $300 premium and require $3000 in margin -- only a 10% return.

It's really the difference between whether you want to make $50,000 over 10 years or make $500,000 over 10 years.

Margin requirements can be even further reduced in the futures market due to the SPAN margin system, which takes into account your whole portfolio when determining your overall risk exposure. My favorite trade type that takes advantage of this is a short option strangle, which allows you to significantly increase your return on investment. I'll talk about SPAN margin and Strangles in my next post.

As for the authors' 3rd reason for why to trade futures options, that being that the futures options markets are more liquid, I don't think the statement has much weight. I haven't done any equities option selling, but I can't imagine it being less liquid than what I see in the futures options markets. Some commodities hardly have any options traded in a day. Yes, I'm looking at you, Cocoa -- not a single trade of the May options at any strike price over 2 days. And the bid/ask spreads, if there actually are any bids or asks, are simply insane. So the futures options markets are anything but easy to trade in.

Option Selling - Part 3 - The Book and The Strategy

After researching books on option selling, I ended up buying the book "The Complete Guide to Option Selling (2nd edition)" by James Cordier & Michael Gross.

This is the book to buy if you're interested in option selling in the futures market. Actually, I think it is the only book out there devoted to the topic, but thankfully it is a great book written by experts who explain things very clearly, and whose views I could fully agree with every step of the way. However, do NOT buy this book to learn about the futures market or options trading, as it does assume you have some knowledge in these areas. I skimmed some good introductory books in Chapters/Indigo a long time ago, but I don't remember their titles.

In the book, they present a fairly specific approach to selling options, and they sold me (no pun intended) on their techniques, even completely changing my mind on a few key strategies (longer-term vs. shorter term options and naked selling vs. spreads).

James Cordier's company is Liberty Trading group, and their website is here: http://www.libertytradinggroup.com/

Oh, and I should've posted this perfect introduction to option selling from their site for my "Why Sell Options" post: http://www.libertytradinggroup.com/benefits.html

But the point of this post is to point out the core strategy that I'm following, which is explained here: http://www.libertytradinggroup.com/strategy.html

Since the above links explain the concepts so well, there's nothing really for me to add here. If you're too lazy to read the links, the core concepts are:

1) Knowing your fundamentals

2) Selling with 3-5 months to expiry

3) Selling deep out-of-the-money options (as in 50 - 100% out-of-the-money).

4) Proper risk management.

The only thing I've noticed in my trading adventures so far is that it's really hard to find an option that's 50 - 100% out-of-the-money with any decent premium. Although, I guess I've been looking closer to the 3-month expiry dates than the 5 month ones. I need to learn to not be so scared to go out longer term. However, I still think those percentages don't make sense in some commodities. For example, with gold, knowing the fundamentals (concept #1), you know trying to sell gold puts at $550 (50% of price) is ridiculous -- everyone else knows this too, which is why you can't get a gold put at that strike price for even $20. So I think there's some leeway in those percentages. But the key is to go farther out of the money than you think (I'm already close to getting burnt by not following this advice in one of my trades).

Option Selling - Part 2 - Why Sell Options?

So what are the main reasons for selling options?

1. Odds are on your side

Studies have shown that about 80% of options expire worthless. This holds true in bull and bear markets, for both put and call options. The large majority of those who buy and hold options will lose 100% of the premium they paid for it. For a detailed article on these stats, see this article: http://www.tribecacapital.com/pages/sellers_vs_buyers.pdf.

As the article mentions, more than 80% of the buyers are actually losing money, because even if an option expires in-the-money, the buyer had to pay a premium for the option, and so the option would have to expire a certain percentage higher than the strike price for them to break-even. There's certainly a large number of options that expire in the money but where the buyer still comes out at a net loss. The only unfortunate thing about the study is that there is no information on the percentage of people who still make a profit on options that end up expiring worthless by selling the option before expiration - e.g. selling during a temporary price spike.

I'm surprised at the 80% number, but I guess it just shows how the option contracts that are out there are not evenly distributed around the asset price. For 80% of the options to be expiring worthless, most people must be "gambling" on out-of-the-money strike prices that are rarely ever going to be reached.

If we only look at options that are far out-of-the-money, the odds of them expiring worthless are obviously higher. You're looking at maybe a 95% chance of keeping the buyer's premium if you sell these options. Of course, the farther out of the money you go, the lower the premium you'll receive, so there's a balance to find.

By being a seller of options, you already start with the odds on your side before you even make a trade.

2. No need to predict where the market will go

Let's say gold is at $1000 and you think it will go down. You could sell a gold futures contract. However, if you guess the direction of the gold price incorrectly, of course you will lose money as gold rises. But even worse is that when you're right about the longer-term direction, you can still lose money from short-term moves. For example, gold might spike to $1050 and you might be forced to exit your trade at a loss as part of your risk management (as you're already at a $5000 loss now). But gold could then reverse and drop to $950, meaning you were right about the direction in the end, but you still lost money on the trade due to the volatility.

Now let's say you instead had decided to sell a gold call option at a strike price of $1300, which expires in 3 months, and you get $500 for this sale. Gold can stay the same, drop, or even go up, and as long as it is under $1300 at expiry you keep the $500 premium from the buyer. Even if you were completely wrong and gold skyrocketed a whopping $250 to $1250 at expiry, you'd still keep the $500 premium. (And even if gold were to skyrocket to $1250 before expiry, you'd likely be able to get out at less than the $5000 loss you would have taken with the futures contract itself when its price reached a mere $1050. Note: this addresses point #5 later on.)

This is one of the best things about selling options. You can be completely wrong about the direction of the market (as we traders often are) and still make consistent profits, as long as you are selling far enough out of the money and not overpositioning yourself (i.e. being greedy).

3. Time is on your side.

For an option buyer, every day that goes by, the option loses some of the "time value" that makes up the premium of the option. If the underlying security doesn't move, time will gradually erode the value of the option. Option buyers know how depressing it is watching your option gradually lose its value while you wait for a move in the underlying asset.

As an option seller, time is always working for you. When selling far out-of-the-money options, ALL of the value of the option is time value and this time value can drop quite quickly. For most options you sell, you will be able to buy the option back a month before expiry to close out the trade early for almost nothing. This allows you to capture most of the potential profit early and get into some other trade, instead of waiting another month to just collect a measly extra $50 or so.

4. It's easy.

Do you stress out about timing your trade entries, figuring out when to exit when the trade goes against you, find it hard to monitor the markets daily - or hourly? With selling options, you simply enter your trade and wait. You don't have to time things perfectly (you might not collect as big of premium if your timing is off, but even movements against your position will likely not affect you if you are far enough out of the money). It's easy to take profits... because you don't have to! You just sit and wait and let the option expire worthless -- no action required on your part. It's much less stressful too, as even a move against your trade is of no concern unless it's a significant move.

5. Lower risk than owning the underlying asset (in my opinion)

I may try to provide a realistic example of this some other time, but knowing me, I won't get around to it. The gold example in point #2 above pretty much illustrates the point.

And those are the key benefits to selling options.

Option Selling - Part 1 - Introduction

I mentioned a while back that I've discovered my trading destiny and would post about it. Well here it is...

The investment approach I am going to be following in my futures trading account from this point forward is Option Selling, also known as Option Writing. More specifically, I will be selling far out-of-the-money naked options on futures with 2-4 months until expiry. I believe this is the ultimate strategy for making consistent small profitable trades that will result in an average portfolio return of about 50% per year.

What is Option Selling?

Most investors have heard about options. If not, there are many places you can read about options trading, such as here: http://www.investopedia.com/university/options/option.asp.

Usually only the buying of call or put options is discussed. But think about it -- when you buy an option, you are buying from someone who is selling, or writing, that option contract. The buyer pays the seller a premium for the contract, and the seller keeps this full premium as long as the underlying instrument does not reach the strike price.

As an option seller, you are no longer predicting or betting on where the price will go; you are picking a price level (usually an extreme one) and betting that the price will not go there. You can be completely wrong about the direction that the price ends up moving and still make money, as long as it doesn't reach your extreme price level.

A Comparison:

Selling options is often compared to selling insurance. Say I own a car insurance company. I might sell a 1-year contract to 1000 drivers at an average of $1000 per contract for a total of $1 million. i.e. the buyers each pay me a $1000 premium to protect them if they get in an accident. I know that 90% of these drivers will not end up using their insurance for the year. The other 10% (100) of those drivers that get into accidents and choose to use their insurance will cost me an average of about $4000 per accident. That's $400,000 I have to pay out. $1 million in premiums - $400,000 in payouts = a profit of $600,000. Not bad.

I ensure that the 10% figure will stay that low buy only selling insurance to low-risk drivers. If I were to sell to high-risk drivers, I might charge a $2500 premium.

Insurance companies are just playing the odds, and making sure those odds are always in their favour. And that is why insurance companies are always profitable.

Now this example isn't perfect, because in the options world we don't have to sit by and watch while "accidents" happen. In the car insurance world, you can't control the fact that there might be a $1 million claim that comes up. But imagine for a moment if I could monitor all the cars in real-time, and when I see an accident about to happen, I could slow down time itself to bullet-time. So I see Joe starting to slide on some ice and headed for another vehicle. There's a chance his car might get totaled, which would cost me, say, $20,000. So I phone Joe up while he's sliding and say, "hey, I'll make you an offer: I'll give you your $1000 back PLUS an extra $3000 to cancel our contract right now". Joe thinks he can avoid the vehicle, and if not, it will just be a fender-bender, and so he says "Deal. Sweet!" And we're both happy.

In the options world we can manage our risk during the lifetime of the trade like in the above example. When selling far out-of-the-money options, we always have plenty of time to get out at a reasonable loss even if there is a severe move in the market.

A quick note on risk:

Usually any mention of selling options is relegated to a paragraph on how it is extremely risky (unlimited risk!), extremely complicated, requires huge amounts of capital, and is a technique only employed by full-time professional traders, and everyone should stay away from it!

The truth is that selling an option -- even naked selling -- is no more risky than buying/selling the underlying stock/futures contract itself, and usually much less risky when done properly. One quick example is described here: http://daytrading.about.com/od/options/qt/ShortOptionsRisk.htm.

Option selling is not understood by even most professionals, and the exaggerations of risk and misinformation around selling options are just perpetuated by such professionals. This myth of incredible risk is so pervasive that is hard to convince people otherwise, and it means that most people stay far away from selling options.

Selling options on futures is more risky than selling equity options, but only because of the leverage that exists in the futures market, not anything to do with option selling itself. In other words, selling a futures option is typically no more risky than buying/selling a futures contract itself, and when done properly, is way less risky. I will try to talk more about risk some other time.

Summary

I should have just linked to this article, because it covers everything I've said and much more, and is way clearer than what I've written.

Next Steps:

Here are the topics I hope to cover over my next set of posts:

- Why Sell Options?

- The Strategy

- Futures Options vs. Equity Options

- 50% return? Yeah right.

- Risk: Naked Selling versus Spreads

- Risk: Selling Options is less risky than owning the underlying asset?

- My trades so far and potential trades - Sugar, Gold, Orange Juice

- Strangles

Sprott And Gold Update

Everyone knows from practically my first post that Eric Sprott is my idol, and I haven't mentioned Sprott in a while, so it's probably a good time to do that.

For anyone who thinks that the worst is over and everything is hunky-dory, please read the latest (October, 2009) "Markets at a Glance" article by Eric Sprott here: http://www.sprott.com/main3.aspx?id=54.

If that article isn't enough to scare you, I don't know what is. And remember, Eric Sprott is alway right :)

Who knows how this state of affairs will eventually affect the markets, but it seems that one thing is fairly certain: the U.S. dollar is toast. Other countries have begun to recognize this. As mentioned in the article, countries have historically supported their own currencies by stockpiling about 63% of their foreign currency holdings in US dollars on average, and this number is now down to 37%.

Furthermore, today the IMF sold 200 tonnes -- or $ 6.7 BILLION worth -- of gold bullion to India. Details and commentary are here:

http://www.businessday.co.za/articles/Content.aspx?id=85875

This was about half of a previously-planned sale by the IMF, but no one expected one big transaction like this. People are speculating China may buy the other half. This is further evidence that countries are trying to get away from the U.S. dollar. This news caused gold to shoot up from $1060 to $1085 today, even while the U.S. dollar was up.

This is great for my Sprott mutual funds holdings, which as you know are heavy in precious metals and energy. (Yes, most of my investments are still in Sprott funds, even though I've been focusing on my trials in short-term trading this last year or so). I just checked the Year-to-date numbers for the funds I'm in:

Sprott Fund YTD returns:

• Sprott Gold & Precious Metals Fund: +90%
• Sprott Energy Fund: +52%
• Sprott Canadian Equity Fund: +26%

Not bad, however they still haven't made back the brutal losses from last year. Remember, you need a 100% gain to recover from a 50% loss.

While gold could pull-back short term, I'm still a big believer in holding gold for the long term. I agree with the guys at Sprott that gold is gradually on its way to $2000 over the next few years. Everyone laughed at them at all their previous gold price predictions, but they all came true.

Natural Gas - Final Trade Update

I am now out of Natural Gas, and I actually ended up making a small profit in the end.

I closed out my December contract at $4.84 today (which I had went short on at $5.00) for a $400 gain. Combining that with my November contract that I lost $150 on, my final outcome of my natural gas trades was a very small profit of about +$220 after commissions.

The warmer weather and maxed out natural gas reserves has caused natural gas to finally come down as expected. That cold snap in October combined with other factors that caused the price to rise sure had me scared for a while -- as I mentioned, I was down almost $4000 at one point. But the fundamentals prevailed in the end.

There is still weakness in natural gas for the short-term, but it is too risky to bet on this now with winter approaching. And besides, I am moving on to bigger and better things...