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