Update

Just a quick update as I really need to get to bed...

Cotton:

Cotton still staying around the 102 mark. Sentiment has really changed. The steam for the rally has temporarily run out, due to a combination of factors:

-India announced crops are a lot bigger than they thought.

-India stopped flip-flopping on whether or not they would hoard all their sugar longer to make sure they had enough for themselves. Now they're all like, "don't worry guys, we'll let you have sugar starting Nov.1.".

-End of quarter, so hedge funds who made a killing on the run up were booking their profits.

-Chinese traders are going on holiday Oct.1 - Oct.7, so trading is lightening up.

The price still seems strong though, as it can't seem to break below the 100 barrier. I had an order in to exit my 120 calls at my entry price (0.60), but they still traded around 0.79-0.94 today. I may try to exit again in the morning, unless the futures drop below 100, then I'll wait until next week.

Sugar:

Huge drop in sugar, so I've already made 30% of my premium on my 35 cent calls. I feel quite safe in this trade now. News is out that the crops are going to be huge next year (I thought that a year ago, when prices were high and everyone was planting tons of sugar, everyone knew this would happen... I guess the weather still had to be good though). The futures rarely lie -- the futures being in backwardation foretold that this would occur. Easy trade, easy money.

Natural gas:

Okay, I'm all ready to *buy* a natural gas option as I mentioned before. Thursday's storage report showed higher than expected storage numbers. Storage levels are not quite as high as last year, but still way above average, and demand is still low. Futures price has dropped to 3.85 and is equivalent to the spot price -- no premium built in. I should buy right now, but I'm going to wait until Monday and buy if the price is still this low or lower - I'm hoping the price will drop to 3.50, but I'm afraid a rally will start anytime. The odds are good that the big funds will all be buying as usual in October in preparation for heating season when demand picks up. It's a bit of a gamble trade for me as I'll only have about 3 weeks until expiry on the options. The 1 ATM options will cost about $2000, and the futures price will have to rise 0.20 in those 3 weeks for me to break even. Then it's about $1000 in gains for every 0.10 rise in price ($10,000 for a $1 rise). I'm pretty sure that near the end of October, NG will be above $4, so I think it's a good "gambling" trade.

Bunch o' Updates

11-month Portfolio Performance:

I'd like to say my option selling portfolio is up 90+%, because that's what it would be without my cotton trade. Instead, I'm back down to 80%. My cotton trade has caused a 6% portfolio loss, which appears as a 10% drop in my overall percentage gain. (simple example: If you turn $100 into $200 -- a 100% gain, and then you get a 5% loss on that $200, your account value is now $190. So your 100% gain now is only a 90% gain -- a 10% difference. This is because the 5% loss is on the current value, which was 2x the original value, and that equals a 10% drop based on the original value).

Cotton Update:

Yesterday, Dec cotton futures moved the daily limit of 4 cents, rising from 99.93 cents to 103.93. My 120 cent calls, which I sold for 0.60 cents each, ended up at 1.80, 3x the premium I paid, so I planned to exit my trade today.

Today, cotton continued it's rise, at one point going over 106 cents. The 120 calls traded at 2.00. I put in a buy order at 1.80 to exit. The price seemed to be stabilizing so I thought this was a fair price. Did I mention that you're flying blind when trading cotton options on OptionsXPress? They're pit-traded (not electronic), so price updates are slow and you don't see any bid/ask, so you don't know what the "going price" is. Oh, and the options only trade from like 5:15am to 10:15am PST, which makes for interesting trading :)

To attempt to get more visibility into prices by seeing what trades might have occurred that OptionsXpress isn't showing, I checked out the cotton info on TradingCharts (http://futures.tradingcharts.com/marketquotes/CT.html) which I believe shows option trades from the electronic exchange. About an hour before the options closing time, I noticed they showed a trade at 1.50 for the 120 calls. I wanted to modify my order from 1.80 to 1.50, not knowing if it was already too late. I did a "Cancel order", planning to put in the new trade after I was sure my existing order was cancelled. I wasn't sure if maybe my 1.80 order had already been filled and just not reported back to me due to the slow response on pit-traded contracts. But also due to this slow response, now my order was stuck in a "pending cancel" and stayed there until close. I'm just rambling now, but bah, it was frustrating.

Now I'm not sure what to do as the futures price has been dropping all evening, now back down to the 102 range. I still think I want to exit, since this is a dangerous trade. The news is non-stop bullish for cotton. My other option is to buy an equal number of, say, 125 calls to hedge myself -- limiting my losses if cotton goes above 120, but possibly being a cheaper alternative to outright exiting my current trade.

Sugar:

On Sep.24 I sold some Jan Sugar calls (74 days to expiry) at 35 cent strike price, while sugar futures rose to 25 cents. News for sugar is bullish (more bad weather, poor crops, etc.), and people are calling for 30 cent sugar, but they're also saying that it would be tough to break through that barrier. Furthermore, the Feb,2011 futures contract is a full cent lower than the Oct,2010 contract, and each further-out contract is lower than the previous. So just like last year, the futures tell the story that investors expect the price to drop, even if there is a temporary surge in prices. We'll have to wait and see if this trade will prove itself to be a mistake like my cotton one :)

Other News:

Gold has now surpassed $1300. This is great, as most of my other investments are gold-related -- and will continue to be. There's nothing else worthwhile to be invested in. Onward to $1600! ... oh, but not until my 1500 calls I'm selling have expired :)

Cotton and Orange Juice

Cotton:

I think I jumped the gun on this one. Option sellers like when there is large move in a commodity and the option premiums on that side go way up. With cotton moving up to 96 cents, I finally sold some $1.20 call options. However, cotton has since skyrocketed to $1.02, and the premium on my $1.20 options has risen 2.5x. My general rule of thumb is to exit a trade at a loss if the premium has increased by 3x.

My mistake in this trade was going against a strong rally AND against the fundamentals -- that is, ignoring the fact that even though cotton prices are nearing all-time highs, they deserve to be at this level and were poised to go higher. I even knew that cotton was trading at $1.13 in some places in China (and apparently at $1.40, as I've now read). It seems there is a bit of a short squeeze going on now too as traders on the short side are running out of margin. There is apparently not much resistance until you get to the $1.17 level (the all-time high). Still, most people seem to be saying that cotton is in a bit of a bubble now, and only panic buying will cause it to move higher. But who knows how much longer the panic buying will continue. If the current price rises much higher, I can't justify the risk and will have to exit the trade at a large loss.

Orange Juice:

Orange juice is experiencing a pretty big rise too - it moved its 1-day limit of 10 cents today, to close around $1.60, all on fears of a tropical storm forming that could hit Florida and damage crops. I'm looking to sell calls in this situation, of course :) This situation is quite different than cotton though. Florida's orange harvest is expected to be on par with last year's, and demand for orange juice hasn't been as low as it is now since the late 1990's. So the only thing driving the rally is the fear of a storm damaging crops.

So when selling calls here, it's basically a gamble on the storm -- in most cases you'll win (first it has to actually form, then it has to hit Florida, then it actually has to do some damage), but you have to be prepared for the worst. The highest price orange juice futures have ever traded is $2.09, and I'm looking to sell calls around $2.40. So I think this trade would be much safer than the cotton one.

Current trades:

My other trades are going perfectly:

- I exited my $100 oil calls after making 75% of my potential profit (the usual point at which I exit a trade). This was a perfect example of trading the fundamentals. The economy is still weak and there is a huge oversupply of oil. People were overly optimistic about economic recovery and I couldn't believe oil kept rising to close to $80.

- I have a $1100/$1500 gold strangle (sell $1100 puts, sell $1500 calls). Because I've always expected gold to keep rising, I only sell calls at very high levels ($250-$300 above current price). This has served me well, as gold has risen about $100 since my $1500 call trade, now at a price of almost $1300, and my $1500 calls are still quite safe. I expect to exit this trade in a week or two.

- I have a 0.87/1.025 CAD strangle. The 1.025 call trade was a bad one -- way too close to the money. I got impatient as I really wanted to be in a strangle, and didn't wait long enough for a good rally in the CAD to be able to get good premiums at a higher level. The CAD can move 5 cents in a day so I like to trade around 10 cents away. If the CAD stays at current levels, I'll be exiting the 0.87 puts later this week as I should reach about 75% of my potential profit.

Option Selling Update

A little while ago I decided it was time to go really go all out with my option selling. After 8 months of trading a fairly small portfolio, I felt I now had a pretty good feel for trading these markets. I'd experienced some dramatic moves in my positions, got exposure to a fairly diverse number of commodities, and confirmed my trading rules of thumb that help guarantee me a good chance of 50-100+% returns per year.

So at the end of July, I started increasing my account size considerably and now trade a very large account. I made some really good trades in the first month (especially Natural Gas, Gold, and Soybeans). I made 5% in the 1st month, and that was while gradually ramping up the size of the account. That makes my 10-month portfolio performance equal to about 82% (due to compounding), and so I'm on target to reach about a 100% one year portfolio gain -- we'll see though. That works out to about a 6% monthly gain, and I hope to continue that average going forward.

I'm currently in trades on Gold, the Canadian Dollar, and Oil. Here's what I'm keeping my eye on for potential upcoming trades:

Sugar:

One of my first trades was with sugar when it was crazy high at 26 cents or so, and I was selling calls at 38 cents at really high premiums since everyone thought it could keep rising. Well it eventually dropped to 14 cents or something after that and there have been no good premiums at safe distances in price. But recently it's risen above 20 cents again. I have to look at what people are saying and if the fundamentals really justify the price, but usually fears of shortages are overblown, just like last year. So I may look at selling some calls.

Cotton:

I have never traded cotton, and I don't really know anything about it. But it is reaching crazy all-time highs. World-wide stocks are at the lowest since 1990, demand is high, crops have been disappointing everywhere, and Tropical Storm Hermine is threatening more US crops. So Cotton is around 92 cents, and it looks like the highest it ever reached was close to 120 cents in 1995. There are some really good call options at 120 cents with only 66 days to expiry that I'm looking at selling. I don't know if that strike price is too risky though. I probably need to look into it more.

Natural gas:

Believe or not, I'm actually looking to buy call options on NG. It's the same story as last year: storage levels are very high and demand is really low, and so the price has been plummeting. Spot price has gotten below $3.70 and it is getting about time for a rebound. In history, 70% of the time, natural gas prices rise in September and October. This is what happened last year -- of course the price first dropped like a rock to the $2 range, and then proceeded to rise to $5 before the end of October. This week would historically be the perfect time to buy options that expire at the end of October, but it's really hard to time this right. The bottom could drop out of the price and we could see the $2 range again. Who knows. Also, the futures already price in some expected autumn gains, and so prices really need to rise to be profitable in a call-buying scenario.

9-month performance

Here are some up-to-date stats on my option selling portfolio at about the 9-month mark:

• 9-month portfolio gain: +73% (~6% per month)
• # of completed round-trip trades: 28 (56 individual trades)
• Profitable trades: 26.
• Unprofitable trades: 2
• Average length of trade: 40 days (shortest: 5 days, longest: 93 days)
• Average portfolio gain per completed trade: ~2%
• Average # of simultaneous open positions: 4
• Avg percentage of original premium retained: 70% for profitable trades

While everything looks like it has gone better than expected, I did do something really stupid and encountered a worst-case scenario, and just about lost all my gains because of it...

May Craziness:

One of the important rules is to not overposition yourself. When the Canadian Dollar (CAD) was around 0.98 at the end of april, I sold puts at 0.90. For the CAD, I was at the limit of what I should be putting into one position. However, on the morning of May 6th, the CAD started to drop and the premiums were rising, and I didn't want to miss out, so I sold some 0.86 puts as well.

Of course, the May 6th craziness happened that afternoon, and the CAD matched its biggest ever intraday point move -- about a 4 cent drop to 0.93 cents before recovering a bit. What was scariest was that there were no "asks" during the few hours when the price was plumetting, so I don't know if I could have exited my trade if I wanted to. That's something I never expected -- that in a worst-case scenario, I may not be able to get out of a trade because liquidity just disappears. When the asks started showing up again, my 0.90 puts were at 7x their value.

I usually place my trades such that I can easily handle a 10x increase in premium, even 20x. But in this case I had double my normal position. I never did exit the trade, as the dollar started recovering. but it gets worse...

Later in May, the dollar had recovered pretty good, but the premiums were still nice and high on the puts, and I bought some 0.89 puts. Now I was 3x overpositioned in the CAD. Sure enough, the CAD dropped 2 cents in one day and eventually ended up around 93 cents again. The premiums on each trade were up 6x, 3x, and 2.5x. On top of that, I had some other trades temporarily in the red, and so the 50% portfolio gain I had at the beginning of May was now completely wiped out on paper.

My margin was maxed out, so I had to exit a couple of trades at a loss. I should have never entered more CAD trades, and I should've exited them when they reached 3x my premium. I didn't want to lose all I had built up though, and I was fairly confident the CAD would stay above 90 cents. If the CAD dropped anymore, I would've been in big trouble. I got lucky though -- the CAD recovered, and I held onto all the CAD trades until they were profitable again a couple of months later.

The good that came out of this was:

- I saw how the markets behave in a panic situation

- I learned first-hand how important it is not to overposition

- The panic situation kicked some sense into me so I doubt I'll do a stupid move like that again.

- I saw that my "rules" do work (my strike price choices, position limits, exit strategy, etc.), if followed, and with them I can handle a typical "worst-case scenario". Even with being 3x overpositioned and not exiting when I should have, my portfolio was down 'only' 35% in a nightmare of a scenario. Imagine if I only had the one CAD position as I should have, and if I exited it properly. I would've only lost about 10%. (Of course, there's always the never-before-seen worst-case scenario that could theoretically wipe me out, but that's the small risk I take with option selling to make incredible gains)

- It reinforced that the most important thing is to be far enough out of the money.

May Market Crash! No, wait.... Nevermind!

Today was one of the craziest days on the market. The DOW had it's biggest intra-day point drop ever, falling over 1,000 points from 10,800 to just under 10,000 -- over 9%. 9% for an index! Then as quickly as it dropped, it jumped up, closing down only 3% by the end of the day. Here's what the day looked like:

But that wasn't the weirdest part. Accenture, a $40 stock, within a few minutes ended up trading at 4 cents, 1 cent, and then immediately right back up to $40. Here's the full day picture:

And here's the close-up of a single 1 minute timespan at the craziest moment (click the image for a larger version):

Remember, the chart above spans just 1 minute! There were a couple of times when there would be a trade at $30-ish or so, and then the very next trade would occur at 1 cent, and the next trade back at $30-ish. But it wasn't just one single oddball trade caused by some glitch. You can see that there were hundreds of trades (over 400, actually) in this 1 minute that gradually brought the stock price to its knees.

A few other stocks supposedly traded down at the 1 cent level as well. Also, Procter & Gamble, an extremely stable stock, briefly dropped from $60 to just below $40, before immediately returning to $60.

So What Happened?

Markets were already spooked with the riots in Greece today and the whole Greek Debt Crisis. Original sources were trying to place the blame of the market crash on a "fat finger" -- someone accidentally entering a billion-dollar order instead of a million-dollar one, which then supposedly set off a wave of automated selling. But a lot of people are saying that the markets had already dropped a lot before any supposed erroneous trades or price quotes occurred, and the drop was led by large moves in the currency markets.

A summary article:

http://www.reuters.com/article/idUSTRE6455ZG20100506

Here is one article that places the blame on automated high-frequency trading:

http://www.zerohedge.com/article/day-market-almost-died-courtesy-high-frequency-trading

I think it will take a few days for people to fully analyze the situation and for us to get some good, interesting articles on what happened today. I personally think that this is something that could happen any time due to the highly-automated world of trading we now live in, and it's quite scary. The Accenture graph above shows what strange things can happen when only the computers are in control.

I think this quote sums up everything the best:

"We did not know what a stock was worth today, and that is a serious problem," -- Joe Saluzzi of Themis Trading.

6-month Performance

Before talking about the crazy markets today (next post), I thought I should post my 6-month performance numbers. My options trading portfolio was up 50% at the 6-month mark (April 25th, 2010). That's still with no losing trades to date. I don't feel like gathering all the stats, so I'll just leave it at that.

4-month performance

Well I started my option selling adventure with my first trade on Oct.26, 2009, and I've now reached the 4-month mark, Here are some up-to-date stats:

• 4-month portfolio performance: +37%
• # of trades: 11 completed, 3 currently open
• # losing trades: none
• Average trade length: 39 days (shortest: 17 days , longest: 2 months)
• Futures traded: Gold (6 trades), Canadian Dollar (4), Sugar (2), Cocoa (1) , Soybeans (1)
• Avg. percentage of original premium captured: ~66% (e.g. sell for $600, buy back at $200)

What's interesting is most of the trades have been for expiry dates that are almost 4 months out, but I only held them for about 1/3 of that time (39 days on average) and yet made 66% of the total potential premium in that time. This highlights the true option time decay curve I posted, which showed how you can typically capture about 50% of the premium in 1 month (i.e. the option price should halve in about 1 month).

Another thing I noticed is that commissions/fees are eating up about 12% of my trade profit on average -- much higher than I was expecting before I started doing this, but it makes sense. OptionsXpress commissions/fees on futures options are about $15 per contract. For something like the Canadian Dollar, which is a 'smaller' contract than something like Gold, I'll typically sell 2 contracts and buy those back later for a $60 total round-trip cost for something that might only net me around $400.

The Time Decay Lie

The way we make our money in option selling is from time decay. The premium of the option we sell is fully comprised of "time value" and as this erodes, our realized profit increases. So determining when to sell options such that the time decay is maximized is very important to us.

Do a google image search on option time decay and you'll get a bunch of results that all look like this:

Every textbook on options will have this graph. If you naively based your option selling on this graph, you would say it's best to sell options with 1 to 2 months until expiration. It looks like most of the time value is still in the option and it doesn't begin to drop off rapidly until after this point.

It doesn't help when the authors of The Complete Guide To Option Selling, who are supposedly the experts on option selling, reproduce this graph in their book and on their website here, and say "Notice that the value decays the fastest during the last 30-60 days of the option's life". They then go on to advocate selling at 3 - 5 months to expiry, which confuses readers since it seems to contradict what they just said and what the graph shows... but it's all because the graph is a lie!

What these graphs fail to tell you is that they are showing the typical behaviour of an *** At-The-Money *** option. We are selling Far-Out-of-They-Money options, and the difference is huge!

As a simple gut-check that the graph must be wrong, look at any far out-of-the-money option with 30 days remaining until expiry, and you'll see that it is practically worthless. What was once worth maybe $400 with 90 days remaining is lucky to be worth $50 with 30 days remaining. Anyone who has sold options knows that there is no value left by the time you hit the 30 day mark.

So what does a typical out-of-the-money option time decay chart look like? Here's one I put together a few months ago, showing an 82 cent put option strike and 106 cent call option strike for the Canadian Dollar when it was around 94 cents. I simply looked at these strikes in different option months to get an idea of how the price would change over time, assuming the futures price and sentiment didn't change.

Well well well... the curve has completely changed! You could infer from this graph that the farther from expiry, the faster the time value decays -- the exact opposite of what the standard option time decay chart implied!

Now before anyone goes and starts selling options that are 1 year from expiry, please note that:

• the farther away from expiry, the more time the commodity's fundamentals have to shift and the more time the futures contract has to move towards to your strike price. E.g. the CAD could easily move to 0.82 over a full year. Thus, you should be selling farther out-of-the-money the farther you move out in time, which means you won't get as much premium, so it may not be worth it.
• If there is a move against your position, these long-out options often start to behave a little more like At-The-Money options, because if people are thinking there is a shift in the trend, the premium could remain high for a long time. You can't easily wait out these moves. E.g. from 12 months left to 10 months left, an option premium may not change that much depending on how the future's sentiment has changed. However, with a 3-month-to-expiry option, the option almost has to really start losing it's value within 2 months, and you'll have a 3 month maximum time to wait it out.
• The graphs don't always look like this. For example, with Sugar, the futures contracts show that the prediction is for sugar to drop drastically in price in about a year. So the call options that are a year out are actually not much different in price than the ones that are 4 months out.

Based on the trades I've done, the optimal time-to-expiry to trade seems to be around 90 to 130 days to expiry.

I seem to be able to find good value in this range at strikes that seem reasonably safe. With less time than this, the premium is already dropping too much and commissions will eat up a bigger percentage of the premium, or I have to trade too close to the money or overposition myself to get a good premium. With more time than this, it can be hard/frustrating to wait out moves against my position. Also, since more people are trading the closer months, it is harder to trade the farther out months with less liquidity and crazier bid/ask spreads.

As a side note, one rule of thumb I try to follow is that for any option I'm about to sell, I should expect it to halve its value in 1 month. So If I'm looking at a June option, I check out the May contract, and it should currently be at about half the premium of June's at the same strike price. This is just one of many rules of thumbs I follow to help me confirm that the trade I'm making is a good one.

Portfolio Return Graph

This is just a quick follow-up to my last post about making a 50% annual return. Remember, that number was assuming 80% of our trades are successful. Since the largest factor determining portfolio return is that percentage of successful trades, I thought it would be more interesting to see a graph showing this relationship, based on the same formulae from my previous post:

You can see we only need about 60% of our trades to be successful in order to break even, assuming we follow a strict exit strategy on bad trades. If 100% of our trades are successful (which is definitely attainable), we can make almost 120% in a year! And these numbers are actually a little conservative, since the formula assumes most of the trades are held to expiration (the scenario "c" example in the previous post), which in reality should almost never occur.

I'm coming up on the 4 month mark of my option selling adventure. In a couple of weeks I hope to post my 4-month portfolio return, reflect on the trades I've made, and talk about my future plans.