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 :)

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.

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.

Option Selling - Part 6 - 50% Return?

I claimed that I expect to make a 50% annual return on my portfolio with option selling. To see how I might arrive at such a number, let's look at:

1) the expected gain on a successful trade

2) the expected loss on an unsuccessful trade

3) the percentage of successful vs. unsuccessful trades

4) the expected overall portfolio return.

1) Expected Gain on Successful Trade

By following various rules of thumb and with my experience so far in picking what seems to be reasonable trades, it seems I can make about $600 premium on a 4-month trade that should require about $1500 in margin. (This can be linearly scaled within reason - e.g. $450 premium on a 3-month trade for about $1200 margin).

The way I calculate the return on this trade is simply $600 / $1500 = 40% over 4 months.

It should be noted that most people actually calculate this trade return as 66.7%. Because you receive the $600 premium immediately, you can put this money to work in another investment, and so your "effective margin" or "out-of-pocket margin" on the trade is really only $1500 - $600 = $900. $600 / $900 = 66.7%. I'm taking the conservative approach of not allowing the premium to be re-invested, because even though the premium is received upfront, you're not guaranteed to keep that cash until the trade is closed out.

40% return over 4 months is what we will receive if we hold the trade until expiration. However, we often will make a higher percentage return because we don't usually need to hold the trade until expiration.

Let's look at the 3 general scenarios that could occur in the first month of a successful trade:

a) the futures price moves favourably for us (away from our strike price).

b) the futures price stays roughly the same.

c) the futures price moves against us (towards our strike price).

In scenario (a), the option price will drop significantly. The option we sold for $600 may only be worth $200 after 1 month, in which case we'd make $400 if we bought it back, or maybe $350 after commission. This works out to a 23% return on investment in 1 month ($350/$1500).

In scenario (b), based on my observations on far out-of-the-money options, the option price will typically drop to half its value in one month. Again accounting for commissions, we would net at least $250, or 16% in one month.

In scenario (c), the option value may rise or stay roughly the same price (depending on the speed and extent of the futures price move), causing us to stay in the trade. Since we are still talking about successful trades here, even if we have to hold until expiration we will end up keeping the full premium. This is just the simple example first described, which I said nets us 40% in the 4 months, or about 10% per month.

Even if scenario (c) happens most of the time, scenario (b) happens sometimes, and scenario (a) almost never happens, and ignoring compounding on the shorter trades, our average trade (or successive trades) will return over 50% in a 4 month period.

(Example math: 23% monthly return 10% of the time, 16% monthly return 25% of the time, 10% monthly return 65% of the time = 23*0.1 + 16*0.25 + 10*.65 = 12.8% average monthly return * 4 months = 51%)

This isn't even accounting for strangles, where we saw we can significantly increase our rate of return, usually over 60% minimum (if held to expiration) in a 4 month period on both of the 2 trades that comprise the strangle. Again, since we can often exit early, we can expect to average over 65% in a 4 month period on strangles.

2) Expected Loss on Unsuccessful Trade

I haven't yet talked about risk management and how much you can expect to lose on a trade gone bad. Really, it is up to you. The book suggests exiting a trade when the option price doubles. I find this a little too restrictive due to the volatility of option prices, so I would say a good rule of thumb is to exit a trade when the option price triples.

If we sold the option for a value of $600 and it triples to $1800, our loss is the $1800 to buy it back minus the $600 premium we originally received, which equals $1200. Since our initial investment was the $1500 margin, our loss is $1200 / $1500 = 80% loss.

It gets more complicated analyzing strangles because there are 2 trades, one successful and one unsuccessful. A typical strangle would be where we sell a put for $500 and sell a call for $500, for a total $2000 margin requirement. If one option tripled and we bought it back, and we assume the other option expires worthless (a valid assumption), the overall loss would be ($500 + $500 - $1500)/$2000 = -25%. i.e. this is the same as losing 25% on two separate trades.

3. Percentage of successful trades

With no history of trading, I have to make an educated guess on this number. I'm going to estimate I can achieve 80% success rate on single trades and 64% on strangles (since a strangle is two separate trades, supposedly each with an 80% success rate, so there's an 80%*80% = 64% chance of success on the overall strangle).

I know this number is pulled out of the air, and it is the variable that will most affect our overall rate of return, but I think it is a reasonable guess. Only time will tell, of course.

4. Overall Portfolio Return

I'm going to try to make half of my trades part of a strangle (e.g. on 8 trades, 4 would be single trades, and there would be 2 strangles (each comprised of 2 trades of course)). Reviewing the numbers, over a 4 month holding period:

- we expect to make 50% on a successful single trade

- we expect to lose 80% on an unsuccessful single trade

- 80% of the trades will be successful

- we expect to make 65% on the trades that comprise a successful strangle

- we expect to lose 25% on the trades that comprise an unsuccessful strangle

- 64% of the strangles will be successful.

(50%*0.8 - 80%*0.2)*0.5 + (65%*0.64 - 25%*0.36)*0.5 = 12% + 16.3% = 28.3%.

Thus, our 50+% average trade return over 4 months drops to an average 28.3% return when accounting for losing trades.

One important guideline that I'm following is that I will only invest half of the cash in my account and leave the other half as cash. This is a very important rule as you need to make sure you have enough room for margin requirement increases that will occur when trades go against you. Since only half of the portfolio is invested, this turns the 28.3% trade return into an approximate 14% portfolio return over 4 months.

Extending this to a full year, and allowing for compounding, our expected yearly return is (1.14 * 1.14 * 1.14) = 1.48 = 48%.

And there you have it, the math behind how I expect to make about 50% per year (before taxes).

The biggest variable, and the one that will affect my portfolio performance the most, is the percentage of successful vs. unsuccessful trades. Also, it has taken me a while to find trades and get up to half of my account cash invested. If I can't keep half of my cash invested, my overall portfolio performance will suffer.

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