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.